oversight

Budget Issues: Budgeting for Federal Insurance Programs

Published by the Government Accountability Office on 1997-09-30.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                 United States General Accounting Office

GAO              Report to the Chairman, Committee on
                 the Budget, House of Representatives



September 1997
                 BUDGET ISSUES
                 Budgeting for Federal
                 Insurance Programs




GAO/AIMD-97-16
      United States
GAO   General Accounting Office
      Washington, D.C. 20548

      Accounting and Information
      Management Division

      B-275316

      September 30, 1997

      The Honorable John R. Kasich
      Chairman
      Committee on the Budget
      House of Representatives

      Dear Mr. Chairman:

      This report responds to your request that we review the budget treatment of federal insurance
      programs to assess whether the current cash-based budget provides complete information on
      the government’s cost and whether accrual concepts could be used to improve budgeting for
      these programs. As requested, we (1) identified potential approaches for using accrual concepts
      in the budget for insurance programs, (2) highlighted trade-offs among different approaches,
      including the current cash-based budget treatment, and (3) discussed potential implementation
      issues such as cost estimation. We have included a matter for congressional consideration and
      are making a recommendation to the Director of the Office of Management and Budget to
      develop and evaluate risk-assumed cost estimation methods for federal insurance programs.

      We are sending copies of this report to the Ranking Minority Member of your Committee, the
      Director of the Office of Management and Budget, and interested congressional committees. We
      will also make copies available to others upon request. Major contributors to this report are
      listed in appendix VI.

      If you have any questions concerning this report, please call me on (202) 512-9142.

      Sincerely yours,




      Susan J. Irving
      Associate Director, Budget Issues
Executive Summary


             For most federal programs, the cash basis of the federal budget provides
Purpose      adequate information on absolute and comparative costs on which to base
             decisions. However, there are some programs—including federal
             insurance programs—in which the cash consequences of current decisions
             may not be seen for a number of years. For these programs, cash-based
             budgeting may provide not only incomplete but also misleading
             information as to their cost. Concern about improving the information
             available to policymakers about the costs of various commitments has led
             to questions about whether budgeting for these programs should move
             toward an accrual basis under which the net present value of the expected
             cost of the risk assumed by the government would be recognized at the
             time the commitment is extended.

             The Chairman of the House Committee on the Budget asked GAO to review
             the treatment of federal insurance programs in the budget. He requested
             that GAO assess whether the current cash-based reporting provides
             complete information about these programs and whether accrual
             concepts—similar to those used for loans and loan guarantees under the
             Credit Reform Act of 1990—could be used to improve budgeting for these
             programs. He has stated that making the cost of these programs more
             visible will facilitate budget decision-making in a time when difficult
             funding trade-offs must be made. This report (1) examines the
             shortcomings of cash-based budgeting for insurance programs,
             (2) identifies how accrual-based budgeting could improve the recognition
             of insurance program costs and their economic impact, (3) examines
             approaches that could be used to incorporate accrual-based cost
             information in the budget, and (4) identifies implementation issues that
             can be anticipated in changing to accrual-based budgeting for these
             programs.


             The federal budget is the primary financial document of the government.
Background   The Congress and the American people rely on it to frame their
             understanding of significant choices about the role of the federal
             government and to provide them with the information necessary to make
             informed decisions about individual programs and the collective fiscal
             policy of the nation. Historically, government outlays and receipts have
             been reported on a cash basis, i.e., receipts are recorded when received
             and expenditures are recorded when paid, without regard to the period in
             which the taxes or fees were assessed or the costs incurred. Although this
             has the advantage of reflecting the cash borrowing needs of the
             government, over the years, analysts and researchers have raised concerns



             Page 2                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Executive Summary




that cash-based budgeting does not adequately reflect either the cost of
some programs—such as federal credit or insurance—in which cash flows
to and from the government can span many budget periods or the timing
of their impact on economic behavior.1

These concerns led in 1990 to changes in the budgetary treatment of credit
programs. Budgeting for these programs is now done on an accrual basis:
the net present value of the estimated cost to the federal government over
the entire life of a loan or loan guarantee is recognized in the budget at the
time the credit is extended. The same concerns also led in 1992 to a
proposal to change the budget treatment of deposit, pension, and other
insurance programs. Although both GAO and CBO found problems with the
specific proposal, which was not adopted, both agencies endorsed further
exploration of accrual-based budgeting for insurance.2

The shortcomings of the budget’s cash-based reporting for insurance
programs became vividly apparent in the aftermath of the savings and loan
crisis. During the 1980s, as hundreds of institutions became insolvent and
the government’s insurance liabilities mounted, the cash-based budget
failed to provide timely information on the rising cost of deposit
insurance. Although GAO and some industry analysts raised concerns about
the rapidly rising deposit insurance costs that were accruing to the
government, corrective action was delayed and the government’s ultimate
cost increased. The cash-based budget provided little incentive to address
the growing problem because it did not recognize the costs until
institutions were closed and depositors paid. This delayed budget
recognition obscured the program’s, as well as the government’s,
underlying fiscal condition and limited the budget process as a means for
the Congress to assess the problem. These shortcomings of the cash-based
budget led some analysts to suggest that the earlier recognition of costs
under an accrual-based budgeting approach might have prompted quicker
action to address the growing deposit insurance commitments and thus
limited the government’s ultimate cost.

The magnitude of federal insurance commitments shown in
table 1—approximately $5 trillion in fiscal year 1995—and the risk for
significant future costs make consideration of how best to provide
adequate information on them important. While more than half of this


1
 The cash basis adequately measures the amount and timing of government borrowing, but for some
programs, such as credit and insurance, it misstates the size and timing of the impact of the
government’s spending on private economic behavior.
2
 For additional detail, see Accrual Budgeting (GAO/AFMD-92-49R, February 28, 1992).



Page 3                             GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                                   Executive Summary




                                   $5 trillion represented insured deposits at financial institutions, the federal
                                   government also insures individuals and firms against a variety of risks
                                   ranging from natural disasters under the flood and crop insurance
                                   programs to employer bankruptcies under the pension insurance program.
                                   Other programs include life insurance for veterans and federal employees,
                                   political risk insurance for overseas investment, and programs covering
                                   vaccine injuries and war risks.

Table 1: Major Federal Insurance
Programs, Fiscal Year 1995         Dollars in billions
                                   Program                                                                            Face value
                                   Bank Deposit Insurance                                                                  $1,919
                                   Private Pension Insurance                                                                  853
                                   Savings Association Deposit Insurance                                                      709
                                   Veterans Life Insurance                                                                    490
                                   Federal Employees’ Group Life Insurance                                                    353
                                   National Flood Insurance                                                                   325
                                   National Credit Union Share Insurance                                                      266
                                   Federal Crop Insurance                                                                          26
                                   Political Risk Insurance                                                                        21
                                   Maritime War-Risk Insurance                                                                      2
                                   Aviation War-Risk Insurance                                                                      2
                                   Vaccine Injury Compensation                                                                      1
                                   Total insurance in force                                                                $4,967
                                   Source: Budget of the United States Government, Fiscal Year 1997 and the Office of Management
                                   and Budget.




                                   The cash-based budget, which focuses on annual cash flows, does not
Results in Brief                   adequately reflect the government’s cost or the economic impact of federal
                                   insurance programs because generally costs are recognized when claims
                                   are paid rather than when the commitment is made. In any particular year,
                                   the cost of the government’s insurance commitments may be understated
                                   or overstated because the time between the receipt of program
                                   collections, the occurrence of an insured event, and the final payment of a
                                   claim can extend over many budget periods. In addition, since it is
                                   generally the issuance of insurance rather than the payment of the claim
                                   that affects economic behavior, the cash-based budget may not accurately
                                   measure the timing and magnitude of an insurance program’s impact on
                                   economic behavior.




                                   Page 4                           GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Executive Summary




As a general principle, decision-making is best informed if the government
recognizes the costs of its commitments at the time it makes them. For
most programs, cash-based budgeting accomplishes this. However, for
insurance programs, accrual-based budgeting, which would recognize the
expected long-term cost of the insurance commitment at the time the
insurance is extended, offers the potential to overcome a number of the
deficiencies of cash-based budgeting by improving cost recognition. In
concept, recognition in the budget of the risk assumed by the government
would permit policymakers to consider these costs in relation to other
funding demands and would improve the measurement of a program’s
impact on private economic behavior. In most cases, the risk-assumed
approach to accrual would be analogous to a premium rate-setting process
in that it looks at the long-term expected cost of an insurance commitment
at the time the insurance commitment is extended. The risk assumed by
the government is essentially that portion of a full risk-based premium not
charged to the insured.

In practical terms, however, attempts to improve cost recognition occur
on a continuum since insurance programs and insurable events vary
significantly. For example, the extent of the improvement in information
in moving from cash-based to accrual-based information would vary
across programs depending on (1) the size and length of the government’s
commitment, (2) the nature of the insured risks, and (3) the extent to
which costs are currently captured in the budget. The diversity of federal
insurance programs also implies that the period used for estimating risk
assumed, the complexity of the models, and the policy responses to this
new information will vary.

The challenges involved in bringing accrual-based estimates into the
budget are significant and dictate beginning with an informational and
analytic step. Development of models to generate reasonably reliable
risk-assumed estimates is made difficult by the nature of the risks insured
by the government, frequent program modifications, and the sufficiency of
data on potential losses. For some programs, the development of
risk-assumed estimates will require refining and adapting available risk
assessment models while, for other programs, new methodologies may
have to be developed. The degree of difficulty in developing estimates and
the uncertainty surrounding these estimates will likely be greatest for
programs—such as deposit and pension insurance—that require modeling
complex interactions between highly uncertain macroeconomic variables
and human behavior. Even after years of research, significant debate and
estimation disparity exists in the modeling for these programs.



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Executive Summary




Despite these challenges, the potential benefits of accrual-based budgeting
for federal insurance programs warrant continued effort in the
development of risk-assumed cost estimates. Supplemental reporting of
risk-assumed estimates in the budget as they are developed over a number
of years would help policymakers understand the extent and nature of the
estimation uncertainty and evaluate whether a more comprehensive
accrual-based budgeting approach should be adopted. In evaluating these
estimates for use in the budget, the focus should not be on whether the
estimates are exactly correct but rather on the improvements in the quality
of budget information they provide to policymakers. Any shift in the way a
program’s costs are reflected in the budget has significant implications for
beneficiaries and taxpayers alike. Better information about the costs of
commitments will permit more informed deliberations about the
appropriate design of insurance programs and about possible responses to
changes in program costs. Given the large stakes involved, it will also be
important that the cost estimates be perceived as unbiased and generally
reliable.

Supplemental reporting of risk-assumed estimates in the budget would
parallel the new accounting treatment required under accounting
standards developed by the Federal Accounting Standards Advisory Board
(FASAB). In requiring the disclosure of risk-assumed estimates as
supplemental information to agency financial statements, FASAB recognized
the usefulness of these estimates to better inform budget decisions. FASAB
also recognized the difficulty of preparing reliable risk-assumed estimates
and therefore did not require their recognition on the financial statements
as a liability. In the interim, as work on the development of risk-assumed
estimates takes place, the claims liability reported in agency financial
statements provide policymakers with useful information on insurance
program losses that are both probable and can be reasonably estimated as
a result of events that have occurred as of a given reporting date. This
information should be considered during budget decisions. However, as
FASAB recognized, the risk-assumed concept would in most cases go
further than the financial statement liability recognition standard since the
latter does not reflect losses inherent in the government’s commitment at
the time the insurance is extended.




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                           Executive Summary




GAO’s Analysis

Cash-Based Budgeting for   Although the cash-based budget may most accurately measure the
Federal Insurance          government’s borrowing needs, for federal insurance it generally provides
Programs Generally         incomplete or misleading information for resource allocation and fiscal
                           policy decisions. The annual net cash flows currently reported in the
Provides Incomplete        budget may obscure the government’s cost for insurance programs
Information for            because premium collections are not matched with the expected costs of
Decision-making            insurance commitments. This occurs for several reasons that vary from
                           program to program depending upon the characteristics of the risk insured
                           and the structure of the program. The mismatch is most obvious for
                           programs in which the government’s commitment extends for many years
                           into the future, such as for life insurance and pension guarantees. For
                           example, from 1981 through 1992 accrued losses of the Pension Benefit
                           Guaranty Corporation (PBGC) ballooned its accumulated deficit as reported
                           in its financial statements from $190 million to $2.4 billion while the
                           cash-based budget reported positive net cash flows every year.3 Thus, PBGC
                           appeared financially sound in the cash-based budget despite its
                           deteriorating condition.

                           Even for programs in which the insurance commitment is short term,
                           cash-based reporting may not be adequate because some risks insured by
                           the government—e.g., flood and crop damage—result in losses that
                           although predictable are nevertheless variable on an annual basis. In order
                           to accumulate reserves to pay claims in high loss years, these programs
                           need more funds than they pay out in other years. Because of their
                           sporadic nature, these risks need to be pooled4 over many years. The
                           annual net cash flows for any single budget year will not accurately reflect
                           the government’s cost for operating such programs on a continuing basis.
                           For example, from 1986 through 1995 the cash-based budget reported
                           premium income exceeding claim payments in 6 of the 10 years for the
                           flood insurance program. This made the program appear in good financial
                           shape, even though a significant portion of the policies receive an
                           unfunded subsidy and the program has not been able to build sufficient
                           reserves to cover expected future high loss years.5

                           3
                            Liability for pension benefit payments is recorded in the financial statements based on events that
                           have occurred or are probable to occur and can be reasonably estimated.
                           4
                            Pooling risk refers to the spreading of risk among a large number of insureds in order to reduce the
                           cost of bearing the risk.
                           5
                            Flood Insurance: Financial Resources May Not Be Sufficient to Meet Future Expected Losses
                           (GAO/RCED-94-80, March 21, 1994).



                           Page 7                              GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                             Executive Summary




                             The cash-based budget also generally falls short as a gauge of the
                             economic impact of federal insurance programs. Although discerning the
                             economic impact of insurance programs is difficult, in general, private
                             economic behavior is affected when insurance is provided rather than
                             when claims are paid. For example, the government may influence the
                             overseas investment decisions of U.S. corporations when it extends
                             political risk insurance and the planting decisions of farmers when it
                             insures their crops.


Accrual-Based Budgeting      The use of accrual-based budgeting for federal insurance programs has the
Has the Potential to         potential to overcome a number of the deficiencies of cash-based
Improve Budget               budgeting. Two characteristics of federal insurance programs support the
                             use of accrual-based budgeting: (1) the government’s commitment to cover
Information and Incentives   future losses that may occur beyond the current budget period and (2) the
for Federal Insurance        difficulty of estimating and pooling insured risk on an annual basis.
Programs
                             As is true of the treatment of loan guarantees under credit reform,
                             accrual-based budgeting for insurance would recognize the estimated cost
                             of the government’s insurance commitments when they are made rather
                             than when the cash consequences occur. Conceptually, therefore,
                             accrual-based budgeting using risk-assumed cost estimates would improve
                             both the opportunities and incentives to control the government’s
                             insurance costs. Policymakers might be encouraged to examine the
                             underlying benefits and structure of insurance programs before coverage
                             is provided—i.e., when a new program is proposed—or before large losses
                             accumulate in existing coverage. They would also be able to make more
                             accurate cost comparisons because risk-assumed cost estimates reflect
                             the government’s subsidy cost—the difference between expected claims
                             and program income—regardless of when cash flows occur. Budgeting for
                             the government’s expected cost of the risk it assumes would take into
                             account the need to pool risks over time and accumulate reserves for
                             future high loss years. Lastly, the earlier recognition of the government’s
                             cost afforded by risk-assumed estimates would more closely coincide with
                             the economic impact of federal insurance programs, which generally
                             occurs when insurance coverage is provided and the risk to the insured is
                             lowered.

                             In practical application, a risk-assumed approach to accrual-based
                             budgeting may vary across programs. The diversity in federal insurance
                             programs means that the period used for estimating risk assumed may
                             differ due to the length of the government’s commitment, the nature of the



                             Page 8                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                            Executive Summary




                            risk insured, and the ability to estimate the risk inherent in the insurance
                            provided. For example, in considering the appropriate method to measure
                            risk it is worth noting the difference between uncertain and predictable
                            but variable events. The occurrence of floods is measurable over the long
                            term but predicting the timing of their occurrence by more than a few days
                            or hours is considered impossible. Thus, while flood losses may be
                            variable on an annual basis, it is possible to measure the long-term
                            expected risk of flooding. However, determining the risk assumed for
                            other programs may be more difficult because they insure events that are
                            not only highly variable but also highly uncertain over the long term. For
                            example, estimating future deposit and pension insurance costs would
                            require assessing the long-term solvency of private firms, which is
                            dependent on highly uncertain and volatile economic, financial, and
                            behavioral variables.

                            In addition, the degree to which accrual-based budgeting would change
                            the information and incentives provided to decisionmakers for insurance
                            programs will vary based on the characteristics of individual programs and
                            the specific approach taken. For example, the limitations of cash-based
                            budgeting and the improvements achieved by shifting to accrual-based
                            budgeting are most pronounced for the two largest programs—deposit and
                            pension insurance. The size of these programs in relation to total federal
                            spending and, therefore, their potential to distort resource allocation and
                            fiscal policy choices have been central to the argument for accrual-based
                            budgeting for federal insurance programs. The failure of the cash-based
                            budget to adequately signal policymakers about the mounting losses from
                            the savings and loan crisis showed that such potentially large
                            misstatements of cost may have serious consequences for aggregate
                            budget and fiscal policy. For other insurance programs, the implications of
                            cash-based budgeting for aggregate budget and fiscal policy may not be as
                            great, but accrual-based reporting could still improve cost information.


Incorporating               The effective implementation of accrual-based budgeting for federal
Accrual-Based Information   insurance programs will depend on the ability to generate reasonable,
in the Budget Presents      unbiased estimates of the risk assumed by the federal government.
                            Although the risk-assumed concept itself is relatively straightforward (the
Estimation and              recognition of the difference between the full risk premium and the actual
Implementation Challenges   premiums charged for the insurance at the time coverage is extended),
                            how to implement it for the wide range of federal insurance programs
                            raises complex issues, such as the appropriate period over which to
                            estimate risk. In addition, substantial effort will be required to improve



                            Page 9                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Executive Summary




available risk assessment models and, in some cases, develop new
methodologies. The extent of these difficulties varies significantly across
the programs. While, in some cases, generating risk-assumed estimates
may not be problematic, in other cases, the difficulties faced may be
considerably more challenging than those currently faced for some loan
programs under credit reform.

Estimating the risks inherent in most federal insurance programs is
difficult for a number of reasons. Many federal insurance programs cover
complex, case-specific, or catastrophic risks that the private sector has
historically been unwilling or unable to cover. As a result, the development
and acceptance of risk assessment methodologies for individual insurance
programs vary considerably. Lack of sufficient historical data for some
federal insurance programs also constrains risk assessment. While private
insurers generally rely on historical data on losses and claim costs to
assess risk, data on the occurrence of insured events over sufficiently long
periods under similar conditions are generally not available for federal
insurance programs. For some programs, such as the war-risk programs,
insured events are extremely rare. For others, such as crop and flood
insurance, the variation in possible outcomes is large, requiring several
decades of data to adequately estimate risks. Frequent program
modifications as well as fundamental changes in the activities insured
further reduce the predictive value of available data and complicate risk
estimation.

Because insurance program costs are dependent on many economic,
behavioral, and environmental variables that cannot be known with
certainty in advance, there will always be uncertainty in reported
accrual-based estimates. This will be true even as models are developed
and improved. It will be important for policymakers to understand the
extent and nature of this uncertainty and to have assurance that the
estimates are unbiased. In addition, as is true for loan programs under
credit reform, budgeting for federal insurance programs would be more
complex under an accrual-based budgeting approach.

In most cases, use of risk-assumed estimates in budgeting for federal
insurance programs, would be more forward looking than the liability
recognition standards traditionally used to prepare financial statements.
For programs with short duration policies, such as crop and flood
insurance, the use of financial statement liability recognition standards
may not yield information very different from what is currently reported
on a cash basis in the budget. For other programs with long-term



Page 10                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                            Executive Summary




                            commitments, such as pension and life insurance, the use of financial
                            statement liability recognition standards would improve the information
                            available in the budget compared to the cash basis. However,
                            accrual-based budgeting using traditional financial statement liability
                            recognition standards, in most cases, would not provide recognition of the
                            risks inherent in the government’s commitment at the time insurance is
                            extended and, thus, would not be as useful for budgeting as the
                            risk-assumed concept. Nevertheless, until risk-assumed estimates are fully
                            developed, and the new accounting standards developed by FASAB are
                            implemented, insurance programs’ financial statements, which are
                            included in the budget appendix, provide policymakers with valuable
                            information on insured events (losses) that are probable and measurable
                            as of a given date and should be considered in budget discussions.

                            Although the characteristics of the risk assumed by the government under
                            the various federal insurance programs make risk estimation difficult,
                            continued research and development of estimation techniques could
                            improve information on and increase attention given to the cost of the
                            government’s commitments. For example, the Office of Management and
                            Budget’s effort to develop methodologies to estimate the future costs of
                            pension guarantees has helped focus attention on the risk assumed by the
                            government for this program.


Supplemental Reporting of   Although the potential for risk-assumed accrual-based budgeting for
Risk-Assumed Estimates in   federal insurance programs to address the shortcomings of the current
the Budget Would Help       cash-based approach argues for its implementation, the analytic and
                            implementation issues involved argue for beginning with supplemental
                            information. Supplemental reporting of these estimates in the budget as
                            they are developed over a number of years could help policymakers
                            understand the extent and nature of the estimation uncertainty and
                            evaluate the desirability and feasibility of adopting a more comprehensive
                            accrual-based budgeting approach.

                            Once several years of data have been reported as supplemental
                            information in the budget, these estimates should be evaluated to
                            determine their reliability. In evaluating these estimates, the focus should
                            not be on whether the estimates are exactly correct but rather on how
                            they improve the quality of the information and incentives provided to
                            policymakers in the budget. If the risk-assumed estimates develop
                            sufficiently so that their use in the budget will not introduce an
                            unacceptable level of uncertainty, policymakers could consider whether to



                            Page 11                   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                     Executive Summary




                     move beyond supplemental information and incorporate risk-assumed,
                     accrual-based estimates into budget authority. Beyond that, full
                     integration of accrual-based estimates into budget authority, outlays, and
                     the deficit could follow if it seemed appropriate and helpful.

                     Supplemental reporting of risk-assumed cost estimates in the budget
                     would allow time to

                 •   develop and refine estimation methodologies,
                 •   assess the reliability of the risk-assumed estimates,
                 •   gain experience and confidence in the risk-assumed cost measures,
                 •   evaluate the feasibility of a more comprehensive accrual-based budgeting
                     approach, and
                 •   formulate cost-effective reporting procedures and requirements.

                     During this period, policymakers should continue to draw on information
                     provided in audited financial statements. As noted above, financial
                     statements provide earlier recognition of accruing liabilities than does the
                     cash-based budget for insurance commitments. Where applicable, agency
                     efforts to comply with accounting standards recently developed by FASAB,
                     which require disclosure of the risk-assumed estimates as supplemental
                     information to agency financial statements, could facilitate the reporting
                     of risk-assumed estimates in the budget. In addition, the ongoing efforts of
                     various interagency working groups to identify ways to comply with credit
                     reform at the lowest possible cost, improve and standardize audit
                     requirements, and use credit reform data and concepts for internal
                     management purposes may be helpful in addressing challenges faced in
                     implementing accrual-based budgeting for federal insurance programs.


                     The Congress may wish to consider encouraging the development and
Matter for           subsequent reporting of annual risk-assumed cost estimates in conjunction
Congressional        with the cash-based estimates for all federal insurance programs in the
Consideration        President’s budget. The Congress may also wish to consider periodically
                     overseeing and assessing the reliability and usefulness of these estimates,
                     making adjustments, and determining whether to move toward a more
                     comprehensive accrual-based budgeting approach for insurance programs.


                     GAOrecommends that the Director of the Office of Management and
Recommendation       Budget develop risk-assumed cost estimation methods for federal




                     Page 12                   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                  Executive Summary




                  insurance programs and encourage similar efforts at agencies with
                  insurance programs. As they become available, the risk-assumed estimates
                  should be reported annually in a standardized format for all insurance
                  programs as supplemental information along with the cash-based
                  estimates. A description of the estimation methodologies used and
                  significant assumptions made should be provided. To promote confidence
                  in risk-assumed cost measures, the estimation models and data should be
                  available to all parties involved in making budget estimates and be subject
                  to periodic external review. As data become available, OMB should
                  undertake and report on evaluations of the validity and reliability of the
                  reported estimates.

                  OMB  officials reviewed a draft of this report and agreed with GAO’s
Agency Comments   conclusion that budgeting for insurance programs should be based on the
                  government’s long-term expected cost of the insurance extended—the risk
                  assumed by the government. OMB also concurred with the report’s findings
                  that the challenges involved in bringing risk-assumed estimates into the
                  budget are significant and that additional effort to improve estimation
                  methods is required. OMB officials noted that they would like to pursue
                  such improvements but are not doing so because they do not currently
                  have the additional expertise that would be required.

                  OMB  officials expressed concern about GAO’s use of the terms “cash” and
                  “accrual” in this report to describe different approaches to budgeting for
                  insurance programs. OMB officials suggested that the current federal
                  budget system is better characterized as commitment-based or
                  obligation-based budgeting and that the use of risk-assumed cost estimates
                  is consistent with this concept. While GAO agrees that this is a useful way
                  of thinking about potential changes in budgeting for insurance programs, it
                  uses the term “cash-based” because cash is the measurement basis for the
                  amounts shown in the budget for budget authority, obligations, outlays,
                  and receipts. The estimates for these amounts generally are made in terms
                  of cash payments to be made or received. The term “accrual-based” is used
                  in the report because the term “accrual” is generally understood as a basis
                  of measuring cost rather than cash flows.

                  GAO modified relevant sections of the report to clarify its explanation of
                  OMB’s views on the budget treatment of deposit insurance under an
                  accrual-based approach. GAO also dropped from chapter 1 a brief
                  discussion of early budget commissions’ recommendations regarding
                  accrual accounting in the federal government which was not necessary to




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Executive Summary




convey its message. Lastly, OMB officials provided a number of technical
comments, which were incorporated into the report as appropriate.




Page 14                   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Page 15   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Contents



Executive Summary                                                                                   2


Chapter 1                                                                                          22
                       Background                                                                  22
Introduction           Objectives, Scope, and Methodology                                          28

Chapter 2                                                                                          31
                       Federal Insurance Programs Cover a Wide Variety of Risks                    31
Overview of Federal    Characteristics of Federal Insurance Programs Complicate                    33
Insurance Programs       Budget Treatment
                       Key Information for Budget Decision-making—                                 35
                         the Risk Assumed by the Government—Is Not Readily Available
                       Snapshot of Current Budget Treatment                                        39

Chapter 3                                                                                          44
                       Budget Reporting Reflects Choices About the Uses and Functions              44
A Budget Perspective     of the Budget
on Federal Insurance   Cash-Based Budgeting Generally Provides Incomplete                          47
                         Information on Federal Insurance Programs
                       The Implications of Cash-Based Budgeting for Decision-making                58
                         Vary Across Programs

Chapter 4                                                                                          60
                       Characteristics of Federal Insurance Programs Support Use of                60
Accrual-Based            Accrual Concepts
Budgeting Has the      The Risk-Assumed Concept Is Most Appropriate for Budgeting                  62
                         for Federal Insurance Programs
Potential to Improve   Accrual-Based Budgeting Has the Potential to Improve Resource               67
Budget Information       Allocation and Fiscal Policy Decisions
and Incentives for     Benefits of Accrual-Based Budgeting for Individual Federal                  72
                         Insurance Programs Will Depend on Several Factors
Most Federal
Insurance Programs




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Chapter 5                                                                                             74
                        Calculation of Risk Assumed by the Government Is Complex                      74
Estimation              Ability to Estimate the Risk Assumed by the Government Varies                 76
Limitations at Center     Across Programs
                        Risk Assessment for Life Insurance Has Its Foundation in                      77
of Accrual Budgeting      Actuarial Science
Debate                  Disaster Insurance Programs Have Established Rate-Setting                     78
                          Methodologies
                        Lack of Consensus on Risk Assessment Methodology for Deposit                  87
                          Insurance
                        Risk-Assumed Estimation Methodologies for Pension Insurance                   97
                          Not Fully Developed and Tested
                        Other Insurance Programs Also Present Estimation Challenges                  100
                        Estimation Challenges Are the Critical Factor in Use of                      105
                          Risk-Assumed Estimates

Chapter 6                                                                                            107
                        Three General Approaches Offer Progressive Integration of                    107
Approaches for            Accrual-Based Information Into the Budget
Incorporating           Supplemental Approach Would Retain Current Basis of Budget                   108
                          Reporting for Federal Insurance Programs
Accrual-Based           Aggregate Budget Authority Approach Would Introduce Some                     110
Estimates Into the        Accrual Amounts Into the Budget
Budget for Insurance    Aggregate Outlay Approach Incorporates Accruals Into the                     116
                          Primary Budget Data
Programs                Different Approaches to Accrual-Based Budgeting Have Different               123
                          Impact on Information for Budget Decisions
                        Approaches Reflect Differing Views on the Use of Accrual-Based               125
                          Information in Budgeting for Federal Insurance Programs

Chapter 7                                                                                            128
                        Issues Inherent in the Use of Accrual Estimates in the Budget                128
Implementing Accrual    Short-Term Implementation Issues                                             132
Budgeting for Federal   Technical Design Issues                                                      139
Insurance Programs




                        Page 17                   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                      Contents




Chapter 8                                                                                         143
                      Matter for Congressional Consideration                                      146
Conclusions,          Recommendation                                                              146
Recommendation, and   Agency Comments and Our Evaluation                                          147
Agency Comments
Appendixes            Appendix I: Budget Account Structure and Reporting Flows for                150
                        Credit Programs
                      Appendix II: Deposit Insurance                                              152
                      Appendix III: Pension Insurance                                             166
                      Appendix IV: Other Insurance Programs                                       172
                      Appendix V: Comments From the Office of Management and                      218
                        Budget
                      Appendix VI: Major Contributors to This Report                              224

Tables                Table 1: Major Federal Insurance Programs, Fiscal Year 1995                   4
                      Table 2.1: Overview of Federal Insurance Programs Reviewed                   32
                      Table 2.2: Federal Insurance Programs                                        36
                      Table 2.3: Face Value of Major Federal Insurance Programs                    38
                      Table 2.4: Budget Information for Major Federal Insurance                    42
                        Programs
                      Table 3.1: Reasons for Mismatch Between Program Collections                  49
                        and Payments
                      Table 4.1: Usefulness of Cost Recognition Approach for                       66
                        Improving Budget Treatment
                      Table 6.1: Relationship Between Budgetary and Nonbudgetary                  117
                        Accounts
                      Table 6.2: Assessment of Accrual-Based Budgeting Approaches to              124
                        Influence Budget Decision-making

Figures               Figure 2.1: Face Value of Major Federal Insurance Programs by                37
                        Type
                      Figure 3.1: Budgetary Cash Flows Versus Accumulated Deficit                  53
                      Figure 5.1: Options Pricing Theory and Federal Insurance                     91
                      Figure 6.1: Advantages and Disadvantages of the Supplemental                109
                        Approach
                      Figure 6.2: Advantages and Disadvantages of the Aggregate                   112
                        Budget Authority Approach
                      Figure 6.3: Reporting Flow for the Budget Authority Approach                114
                        with Discretionary Option




                      Page 18                  GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
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Figure 6.4: Advantages and Disadvantages of the Aggregate                   116
  Budget Authority Approach With Discretionary Outlay Feature
Figure 6.5: Reporting Flow for the Current Cash-based Approach              118
Figure 6.6: Reporting Flow for the Aggregate Outlay Approach                119
Figure 6.7: Advantages and Disadvantages of the Aggregate                   122
  Outlay Approach
Figure I.1: Simplified Credit Reform Cash Flow                              151
Figure II.1: Bank Deposit Insurance Budget Estimates Versus                 156
  Actual Outlays, Fiscal Years 1973-1996
Figure II.2: Thrift Deposit Insurance Budget Estimates Versus               156
  Actual Outlays, Fiscal Years 1973-1996
Figure II.3: Credit Union Share Insurance Budget Estimates                  159
  Versus Actual Outlays, Fiscal Years 1973-1996
Figure III.1: Pension Benefit Guaranty Corporation Budget                   168
  Estimates Versus Actual Outlays, Fiscal Years 1981-1996
Figure IV.1: Employees’ Life Insurance Fund Budget Estimates                175
  Versus Actual Outlays, Fiscal Years 1973-1996
Figure IV.2: Service-Disabled Veterans Insurance Fund Budget                177
  Estimates Versus Actual Outlays, Fiscal Years 1973-1996
Figure IV.3: NFIP Premium Income Versus Loss and Loss                       183
  Adjustment Expenses, Fiscal Years 1969-1996
Figure IV.4: National Flood Insurance Fund Budget Estimates                 184
  Versus Actual Outlays, Fiscal Years 1973-1996
Figure IV.5: Federal Crop Insurance Premiums Versus Loss and                191
  Loss Adjustments, Fiscal Years 1980-1996
Figure IV.6: FCIC Fund Budget Estimates Versus Actual Outlays,              192
  Fiscal Years 1973-1996
Figure IV.7: OPIC Insurance Premium Collections Versus Claim                199
  Payments, Fiscal Years 1972-1996
Figure IV.8: Aviation Insurance Fund Budget Estimates Versus                205
  Actual Outlays, Fiscal Years 1973-1996
Figure IV.9: War-Risk Insurance Revolving Fund Budget                       207
  Estimates Versus Actual Outlays, Fiscal Years 1973-1996
Figure IV.10: VICP Excise Tax Receipts Versus Obligations for               214
  Claim Compensation, Fiscal Years 1988-1996
Figure IV.11: Vaccine Injury Compensation Program Budget                    215
  Estimates Versus Actual Outlays, Fiscal Years 1989-1996

Abbreviations

AID        Agency for International Development
BEA        Budget Enforcement Act of 1990
BFE        base flood elevation


Page 19                  GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Contents




BIF        Bank Insurance Fund
CAMEL      capital adequacy, asset quality, management practices,
                earnings, and liquidity
CBO        Congressional Budget Office
CCC        Commodity Credit Corporation
CEC        Current Exposure to Claims
CFO        Chief Financial Officer
CRP        Conservation Reserve Program
CUSIF      Credit Union Share Insurance Fund
DELV       damage by elevation
DOD        Department of Defense
DOJ        Department of Justice
DOT        Department of Transportation
ERISA      Employee Retirement Income Security Act of 1974
FAA        Federal Aviation Administration
FASAB      Federal Accounting Standards Advisory Board
FASB       Financial Accounting Standards Board
FCIC       Federal Crop Insurance Corporation
FDA        Food and Drug Administration
FDIC       Federal Deposit Insurance Corporation
FDICIA     FDIC Improvement Act of 1991
FEGLI      Federal Employees’ Group Life Insurance
FEMA       Federal Emergency Management Agency
FFB        Federal Financing Bank
FIA        Federal Insurance Administration
FICO       Financing Corporation
FIRM       flood insurance rate map
FIRREA     Financial Institutions Reform, Recovery, and Enforcement
                Act of 1989
FRS        Federal Reserve System
FSLIC      Federal Savings and Loan Insurance Corporation
GATT       General Agreement on Tariffs and Trade
GPRA       Government Performance and Results Act of 1993
HHS        Department of Health and Human Services
HRSA       Health Resources and Services Administration
HUD        Housing and Urban Development
IBNR       incurred but not yet reported
MARAD      Maritime Administration
NAP        Noninsured Assistance Program
NCUA       National Credit Union Administration
NFIP       National Flood Insurance Program


Page 20                 GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
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OBRA ’90   Omnibus Budget Reconciliation Act of 1990
OCC        Office of the Comptroller of the Currency
OMB        Office of Management and Budget
OPIC       Overseas Private Investment Corporation
OPM        Office of Personnel Management
OTS        Office of Thrift Supervision
PAYGO      pay-as-you-go
PBGC       Pension Benefit Guaranty Corporation
PELV       probability of elevation
PIMS       Pension Insurance Modeling System
RIS        Retirement and Insurance Service
RMA        Risk Management Agency
RPA        Retirement Protection Act of 1994
RTC        Resolution Trust Corporation
SAIF       Savings Association Insurance Fund
SBA        Small Business Administration
SDVI       Service-Disabled Veterans Insurance
SFAS       Statement of Financial Accounting Standards
USDA       Department of Agriculture
VA         Department of Veterans Affairs
VBA        Veterans Benefit Administration
VICP       Vaccine Injury Compensation Program
VMLI       Veterans Mortgage Life Insurance




Page 21                 GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Chapter 1

Introduction


               During the last 50 years, many analysts and researchers have raised
               concerns that cash-based budgeting does not provide complete
               information on the cost of some federal programs. Concerns that the
               cash-based budget badly distorted information on credit programs led to
               the inclusion of accrual-based costs in the budget for credit programs as
               the result of the Federal Credit Reform Act of 1990. Similar concerns have
               been raised about other programs—most notably insurance and federal
               employee pensions. In 1992, the Bush administration proposed to change
               the budget treatment of insurance programs from a cash basis to an
               accrual basis. Although the proposal was not enacted, analysts continue to
               assess the merits of accrual-based budgeting for such programs.

               Because of his concern that for some federal programs, the cash-based
               budget does not provide a complete picture of the consequences of the
               government’s actions, the Chairman of the House Committee on the
               Budget asked us to evaluate the use of accrual-based budgeting for federal
               insurance programs. He believes that making the government’s cost of
               these programs more visible will improve budget decision-making.


               The federal budget serves as the primary financial plan of the government.
Background     As such, difficult decisions concerning resource allocation and fiscal
               policy are framed by the information provided in the budget. Historically,
               government outlays and receipts have been reported on a cash or
               cash-equivalent basis.1 Receipts are recorded when received and
               expenditures are recorded when paid, without regard to the period in
               which taxes and fees were assessed or the costs incurred. For most
               federal programs, cash-based reporting provides adequate information on
               and control over the government’s spending commitments because the
               time between when a liability is incurred and when it is paid is short. Costs
               to the government are known at the time the decision is made to provide
               budget authority, and cash outlays generally capture the fiscal effects of
               the government’s spending. However, for certain programs, such as federal
               insurance in which the government’s commitment can involve cash flows
               to and from the government over many years, the actual cost to the
               government may not be fully recognized with cash-based reporting.

               The failure of the cash-based budget to provide timely signals to
               policymakers on the rapidly deteriorating financial condition of the
               nation’s deposit insurance system and growing federal commitments for

               1
                A long-standing exception to this is interest on public issues of public debt, which is recorded as it
               accrues.



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Chapter 1
Introduction




deposit insurance during the 1980s has been widely cited as a vivid
illustration of the shortfalls of cash budgeting for federal insurance
programs. Although GAO and some industry analysts raised concerns about
the rapidly rising deposit insurance costs that were accruing to the
government, corrective action was delayed and the government’s ultimate
cost increased. If the budget had recognized the government’s expected
cost of deposit insurance, the government’s ultimate cost might have been
lower if such recognition had prompted earlier actions by policymakers to
limit losses. Instead, the budget did not report these costs until institutions
were closed and depositors paid. In addition, by not reflecting the
government’s deposit insurance liabilities as they accrued, the cash-based
budget proved to be a poor gauge of the program’s economic impact.
Delay in recognizing these costs obscured the government’s underlying
fiscal condition during and after the crisis. Furthermore, not only was the
cash-based budget slow to recognize these costs, but it may have also
created incentives to delay closing insolvent institutions (to avoid
increasing the annual deficit), which increased the ultimate cost to the
government.2 This experience with deposit insurance heightened concerns
that the cash-based budget was not providing adequate information on the
potential cost of other federal insurance commitments.

In a series of reports in the 1980s on managing the cost of government, GAO
advocated the use of some accrual cost measures in the budget.3
Specifically, we reported that due to the budget’s exclusive focus on cash
transactions, the costs of some programs, including retirement, insurance,
and credit, may not be accurately reflected in the budget. However, given
the limitations of governmentwide accounting systems, we suggested that
budget reporting could be improved by recording annual accrued costs for
selected programs. Since then, budget reporting has gradually been
modified using accrual measures to recognize the government’s cost for
certain programs. For example, in 1985, budgeting for military retirement
costs was moved to an accrual basis reflecting—at the program level—the
government’s expected costs for retirement benefits as they are earned.
These program level accrued amounts are offset so that total budget
outlays and the deficit are not affected by this change. Similarly, beginning
in 1987, accruing retirement benefit costs not covered by employee
contributions are now charged to employing agencies for civilian
employees covered under the Federal Employees Retirement System.


2
 Budget Issues: 1991 Budget Estimates: What Went Wrong (GAO/OCG-92-1, January 15, 1992).
3
 Managing the Cost of Government: Building an Effective Financial Management Structure
(GAO/AFMD-85-35, February 1985) and Managing the Cost of Government: Proposals for Reforming
Federal Budgeting Practices (GAO/AFMD-90-1, October 1989).



Page 23                           GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                         Chapter 1
                         Introduction




                         More recently, the Federal Credit Reform Act of 1990 changed the method
                         of controlling and accounting for credit programs to an accrual basis.


Credit Reform Marked a   On November 5, 1990, the Federal Credit Reform Act was signed into law,
Significant Departure    as Title 13B of the Omnibus Budget Reconciliation Act of 1990 (Public Law
From Cash-Based          101-508). The act, which legislated changes GAO and others advocated,4
                         addressed many of the concerns raised by various analysts by changing
Budgeting                the budget reporting of the cost of credit programs from a cash basis to an
                         accrual basis. Because the federal government uses loans and loan
                         guarantees to achieve numerous policy objectives, the scope of this
                         change was far-reaching. In fiscal year 1996, for example, the federal
                         government entered into commitments to make or guarantee loans
                         totaling approximately $200 billion.

                         Prior to credit reform, outlays for credit programs were reflected in the
                         budget only when cash was disbursed. The full amount of a direct loan
                         was reported as an outlay, ignoring the fact that many would be repaid. In
                         the case of loan guarantees, initially no outlays were reported. This
                         ignored the fact that some of the guaranteed loans would be defaulted
                         upon and thus require future outlays. Consequently, the cash basis of
                         reporting overstated the cost of direct loans in the year they were made
                         because it ignored repayments and understated the cost of loan guarantees
                         in the year they were issued by ignoring defaults. This deficient reporting
                         skewed cost comparisons between programs with similar purposes but
                         different funding approaches (i.e., direct loans, loan guarantees, or grants).
                         Further, the relative cost of such programs in comparison to other federal
                         spending was also misrepresented. By incorporating accrual cost
                         measures in the budget for loan and loan guarantee programs, credit
                         reform improved these cost comparisons.

                         Credit reform addressed the shortfalls of cash-based reporting for credit
                         program costs by requiring the budget to include the estimated cost to the
                         federal government over the entire life of the loan or loan guarantee,
                         calculated on a net present value basis.5 For purposes of the Credit
                         Reform Act, the estimated cost of a direct loan or loan guarantee is now
                         the sum of all expected costs—including interest rate subsidies and


                         4
                         Budget Reform for the Federal Government (GAO/T-AFMD-88-13, June 7, 1988) and Budget Issues:
                         Budgetary Treatment of Federal Credit Programs (GAO/AFMD-89-42, April 10, 1989).
                         5
                          Present value is the worth of a future stream of returns or costs in terms of money paid today. A
                         dollar today is worth more than a dollar at some date in the future because today’s dollar could be
                         invested and earn interest in the interim.



                         Page 24                             GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                           Chapter 1
                           Introduction




                           estimated default losses—and all expected payments received by the
                           government over the life of the commitment, discounted by the interest
                           rate on Treasury securities of similar maturity to the loan or guarantee.
                           Reestimation of the cost of loans disbursed or guaranteed in a given year
                           is required over the life of the commitment. This more accurate reporting
                           of credit program costs allows for more efficient allocation of budget
                           resources and improved measurement of these programs’ economic
                           impact.


Credit Reform Requires     Credit reform was significant not only because it changed the budget
Recognition of Estimated   reporting for credit programs from a cash basis to an accrual basis but
Costs When the             also because it prescribed a more prospective form of accrual
                           measurement than required by generally accepted accounting standards
Government Enters Into a   used in financial statements prepared prior to credit reform.6 Traditional
Commitment                 accounting standards required the recognition of all losses and expenses
                           incurred during a reporting period, including those that have occurred but
                           have not yet been reported. In other words, a cost would be accrued when
                           it was more likely than not that a borrower had defaulted on his or her
                           loan. In contrast, credit reform requires recognition of the expected costs
                           of new loans and guarantees (on a net present value basis) at the time the
                           credit is extended. This “risk-assumed” approach recognizes the expected
                           cost to the government before the government commits itself to future
                           losses inherent in the credit issued.

                           For example, prior to credit reform, if the government decided to provide
                           $3 million in direct loans, the cash budget would have shown an outlay in
                           the first year of $3 million. Repayments by borrowers would be recorded
                           when received in future years, and, when some borrowers defaulted, net
                           payments received by the government would simply be lower. Under
                           traditional accrual accounting no cost would be shown in the first year
                           since repayment is expected, but in subsequent years when some
                           borrowers defaulted, the unpaid principle would be recognized as a cost.
                           Thus, in neither case was the government’s cost recognized correctly at
                           the time the decision was made to authorize the loans. In contrast, using
                           the risk-assumed basis of credit reform, an estimate of the government’s
                           cost would be recorded when the government made the commitment to
                           provide the loans.



                           6
                            The Federal Accounting Standards Advisory Board (FASAB) subsequently developed accounting
                           standards for credit programs that reflected and supported the prospective accrual measures called for
                           under credit reform.



                           Page 25                            GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                            Chapter 1
                            Introduction




                            Recognizing that the shortcomings of the cash budget are not unique to
                            credit programs, the Congress in the Credit Reform Act directed OMB and
                            the Congressional Budget Office (CBO) to study the possible application of
                            accrual budget reporting for federal deposit insurance programs. In
                            May 1991, CBO reported that the current cash-based budgeting approach
                            for deposit insurance could be improved either through the use of accrual
                            concepts or other reporting alternatives.7 CBO concluded the following:

                            Adopting a full credit reform approach to deposit insurance has one major advantage and
                            one major disadvantage . . . . The advantage is that only the accrual recognition of costs will
                            provide an early warning of financial disaster in the budget. The disadvantage is that
                            estimating the cost of deposit insurance—when cost is incurred—is very difficult.


                            OMB also reported that accrual-based budget reporting for deposit
                            insurance could be an improvement over the current approach and
                            outlined specific financial and econometric models that could be used to
                            estimate deposit insurance costs as they arise. OMB recommended that
                            these cost measures be further developed, tested, and validated before
                            deciding whether or how to bring accrual-based estimates into the budget.8



The Bush Administration     In the President’s fiscal year 1993 budget, less than a year after OMB and
Proposed Extending Credit   CBO reported on the budget treatment of deposit insurance, the Bush

Reform Principles to        administration proposed applying credit reform principles to budgeting for
                            deposit insurance and pension guarantees. Under the proposal, other
Insurance Programs          insurance programs would be moved to an accrual basis the following
                            year. The administration emphasized earlier concerns that cash-based
                            budgeting for insurance programs did not provide clear and timely
                            measurement of their cost to the government. It maintained that budget
                            reporting for these programs on an accrual basis would provide
                            policymakers with the information and incentives necessary to control
                            their costs.

                            The similarities between loan guarantees and federal insurance were
                            noted in the administration’s proposal. In both cases the government
                            commits to paying some or all of future costs under specified conditions in
                            exchange for a fee or premium. As with the new treatment of credit
                            programs, the proposal called for the recognition of the government’s cost

                            7
                              Budgetary Treatment of Deposit Insurance: A Framework for Reform, Congressional Budget Office,
                            May 1991.
                            8
                             Budgeting for Federal Deposit Insurance, Office of Management and Budget, June 1991.



                            Page 26                            GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Chapter 1
Introduction




of new or expanded insurance coverage at the time the insurance is
extended. The cost of the risk assumed by the government would be
estimated on a net present value basis and would include all expected
costs and collections related to the coverage extended. OMB showed
estimates of the new accrual-based measures in the budget for deposit
insurance and pension guarantees. These measures were based on
complex, newly developed estimation methodologies using options pricing
models.9 Legislation to effect the new budget reporting was introduced in
the Congress.

Despite continued concern about the cash basis of reporting for insurance
programs, both GAO and CBO objected to the administration’s proposal at
the time.10 GAO affirmed its long-standing support of reporting
accrual-based costs in the budget but concluded that the proposal made at
that time was flawed. GAO and CBO questioned the sufficiency of available
data and estimation methodologies necessary to make reasonably accurate
accrual cost estimates. Both agencies expressed concern about the rush to
implement a major conceptual and technically challenging change in
budget reporting without thorough study. CBO also reported that by
changing the way shortfalls in program funding would be financed, the
proposal could have increased taxpayer liability for these programs.

Another major concern surrounding the initiative was the budget
treatment of savings stemming from deposit and pension insurance
program reforms that were also proposed. On a cash basis, these savings
would not have been recognized for several years in the budget, but, by
recording their effects on an accrual basis, the administration was able to
show savings in fiscal years 1992 and 1993 to offset revenue lost from
proposed tax reductions. CBO concluded that the savings achieved by the
administration’s program reforms should not be available to pay for other
policy initiatives. As a result, most observers viewed the accrual-based
budgeting proposal as an accounting gimmick rather than a way to
improve budget reporting for insurance programs. The merits of
accrual-based reporting for these programs were overshadowed by these
concerns. No action was taken by the Congress on the legislation.

Since the Bush administration’s proposal for changing the budget
treatment of insurance programs, OMB has continued work on developing

9
 Options pricing models are mathematical models that employ probabilistic functions to value
contracts that give the owners the right to buy or sell an asset (such as a stock) at a fixed price on or
before a given future date. For an additional discussion of options pricing see figure 5.1 in chapter 5.
10
 See Accrual Budgeting (GAO/AFMD-92-49R, February 28, 1992) and An Analysis of the President’s
Budgetary Proposals for Fiscal Year 1993, Congressional Budget Office, March 1992.



Page 27                              GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                     Chapter 1
                     Introduction




                     methodologies to estimate the risk-assumed cost of deposit insurance and
                     pension guarantees. At the request of the Chairman of the House
                     Committee on the Budget and because of continued interest in this area,
                     we undertook this study to more thoroughly develop the issues involved in
                     changing the budget treatment of insurance programs.


                     The Chairman of the House Committee on the Budget asked us to review
Objectives, Scope,   the budget treatment of federal insurance programs to assess whether the
and Methodology      current cash-based budget provides complete information and whether
                     accrual concepts could be used to improve budgeting for these programs.
                     Specifically, we were asked to (1) identify approaches for using accrual
                     concepts in budgeting for insurance programs, (2) highlight trade-offs
                     among different approaches, including the current budget treatment, and
                     (3) discuss potential implementation issues, such as cost estimation.

                     We limited the scope of our study to programs previously identified by OMB
                     and FASAB as federal insurance programs. Programs included in our study
                     are shown in table 2.1. OMB’s list forms the basis of its annual analysis of
                     credit and insurance programs, which, in recent years, has been part of the
                     Analytical Perspectives volume of the President’s budget. We added one
                     program to the OMB list—the Federal Employees’ Group Life Insurance
                     program. This program was included by FASAB as federal insurance in its
                     recommended accounting standards for federal liabilities. Of the veterans
                     life insurance programs underwritten by the federal government, we
                     include only those which are still open to new participants.

                     In undertaking this study, we acknowledge that there is not universal
                     agreement on which programs constitute federal insurance. The programs
                     we included in our analysis share some, but not necessarily all, the
                     characteristics of private insurance. Conversely, some programs not on
                     our list have some of the characteristics of programs on our list. The
                     diversity of the programs undertaken by the federal government could
                     result in disagreement about what constitutes a federal insurance
                     program. Valid arguments may be made for additions to or deletions from
                     the list of insurance programs to consider for an accrual-based budgeting
                     approach. This is but one of many issues policymakers face in
                     incorporating accrual concepts in the budget.

                     To accomplish our objectives, we focused our analysis on the sufficiency
                     of information provided for resource allocation and fiscal policy with the
                     recognition that budget reporting must be understandable and facilitate



                     Page 28                   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Chapter 1
Introduction




budget control and accountability. This premise is grounded in the work of
the 1967 President’s Commission on Budget Concepts, which stressed that
resource allocation and fiscal policy outweigh all other uses of the budget,
such as the cash and debt management activities of the Treasury and
analyses of the impact of federal activity on the financial markets. To
assess the sufficiency of information in the budget for these purposes, we
reviewed the programs’ current budget treatment, consulted with budget
experts, and analyzed historical data on budgeted and actual insurance
outlays.

To develop approaches for using accrual concepts in the budget and to
identify trade-offs among approaches, we began by reviewing the Bush
administration’s 1992 proposal to adopt accrual accounting for federal
insurance programs. We surveyed existing research on the budget
treatment of insurance programs conducted by OMB, CBO, and other budget
analysts. We examined various reports and documents pertaining to the
accrual-based approach for loan and loan guarantee programs prescribed
by the Federal Credit Reform Act of 1990. We studied the accounting
standards for insurance activities promulgated by the Financial
Accounting Standards Board (FASB) for private sector entities and FASAB
for the federal government.

To identify potential implementation issues, we convened panels of
federal insurance agency officials and staff to gather information on the
operation of the programs and the agencies’ risk assessment capabilities.
We also obtained their views on the potential benefits and drawbacks to
the use of accrual-based budgeting. When we could not convene a panel or
when key agency personnel were unavailable, we obtained written
responses to our questions. We also discussed potential implementation
issues with budget experts familiar with the implementation of
accrual-based budgeting for credit programs.

To identify issues related to developing risk-assumed cost estimates, we
interviewed agency actuaries, economists, and other staff responsible for
risk assessment. We also analyzed documentation supplied by the agencies
and prior GAO reports on individual programs. In addition, we retained the
services of an independent contractor to assist us in reviewing OMB’s
options pricing models for deposit insurance and pension guarantees. As
part of the contractor’s review, it assessed the validity of using options
pricing concepts and techniques to estimate insurance liabilities, the
technical sophistication and data requirements of OMB’s models, and the
reliability of OMB’s model estimates for budget and policy decision-making.



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Chapter 1
Introduction




We did not test or validate (1) any of the other estimation methodologies
currently used by the agencies for risk assessment or rate-setting or
(2) any of the methodologies that could potentially be used for these
purposes.

We performed our work in Washington, D.C., from September 1995
through November 1996 in accordance with generally accepted
government auditing standards. We requested written comments on a draft
of this report from the Director of OMB or his designee. The Deputy
Assistant Director, Budget Analysis and Systems, provided comments,
which are discussed in chapter 8 and are reprinted in appendix V.




Page 30                   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Chapter 2

Overview of Federal Insurance Programs


                        Federal insurance programs are a diverse set of programs covering a wide
                        range of risks that the private sector has traditionally been unable or
                        unwilling to cover. From a federal budgeting perspective, these programs
                        present significant challenges because the insured events tend to be
                        catastrophic or volatile in nature and may not occur for years after the
                        government’s commitment is extended. Although several financial
                        measures are available for insurance programs, estimates of the risk
                        assumed by the federal government—the key information for budget
                        decision-making—have been limited. Despite some common elements,
                        these programs vary significantly in several respects, including size, length
                        of the government’s commitment, frequency of activation, and financing.
                        These differences warrant consideration in determining the appropriate
                        budget treatment for these programs.


                        The federal government insures individuals and firms against a wide
Federal Insurance       variety of risks ranging from natural disasters under the flood and crop
Programs Cover a        insurance programs to bank and employer bankruptcies under the deposit
Wide Variety of Risks   and pension insurance programs. Other federal insurance programs
                        provide life insurance for veterans and federal employees and political risk
                        insurance for overseas investment activities. The federal government also
                        provides protection against war-related risks and adverse reactions to
                        vaccinations. Further, in recent years, proposals have called for extending
                        federal insurance activities to cover natural catastrophes, such as
                        earthquakes and volcanic eruptions.1

                        Some federal insurance programs have a statutory intent to provide
                        subsidized coverage while others do not. In some cases, the government
                        subsidizes insurance programs in order to achieve a public policy
                        objective. For example, catastrophic coverage under the crop insurance
                        program is fully subsidized in an attempt to reduce reliance on ad hoc
                        disaster assistance. The Service-Disabled Veterans Insurance Program
                        provides life insurance coverage to veterans with service-connected
                        disabilities based on rates for healthy individuals or free to totally disabled
                        veterans. In other cases, as noted later in this chapter, the federal
                        government may intend to provide unsubsidized insurance. However,
                        regardless of statutory intent, whenever federal insurance is underpriced
                        relative to its long-run cost, those who are insured receive a subsidy

                        1
                         Natural Disaster Insurance: Federal Government’s Interests Insufficiently Protected Given Its
                        Potential Financial Exposure (GAO/T-GGD-96-41, December 5, 1995); Federal Disaster Insurance:
                        Goals Are Good, but Insurance Programs Would Expose the Federal Government to Large Potential
                        Losses (GAO/T-GGD-94-153, May 26, 1994); and Bipartisan Task Force on Funding Disaster Relief,
                        Federal Disaster Assistance, S. Doc. No. 4, 104th Congress, 1st Sess. (1995).



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                                 because premiums will not cover program costs. Table 2.1 provides an
                                 overview of the programs included in our study. More detailed program
                                 summaries are provided in the appendixes to this report.

Table 2.1: Overview of Federal
Insurance Programs Reviewed                                                                     Statutory intent for
                                 Program                       Description                      government subsidy
                                 Aviation War-Risk Insurance   Insures against losses           No; expectation of
                                                               resulting from war,              legislation was that it would
                                                               terrorism, and other hostile     probably be self-financing
                                                               acts when commercial             from premiums for
                                                               insurance is unavailable on      assumption of anticipated
                                                               reasonable terms and             risks.
                                                               conditions and continued
                                                               air service is in the interest
                                                               of U.S. policy.
                                 Bank Deposit Insurance        Insures deposits at              Intent unclear; deposits
                                                               commercial banks and             backed by the full faith and
                                                               some savings banks               credit of the U.S.
                                                               against losses in the event      government.
                                                               of insolvency.
                                 Federal Crop Insurance        Insures against crop             Yes.
                                                               damage from unavoidable
                                                               risks associated with
                                                               adverse weather, plant
                                                               diseases, and insect
                                                               infestations.
                                 Federal Employees’ Group      Provides life insurance to    No.
                                 Life Insurance                federal employees,
                                                               annuitants, and their
                                                               families for accidental death
                                                               and dismemberment.
                                 Maritime War-Risk Insurance   Insures losses resulting         No; expectation of
                                                               from war, terrorism, and         legislation was that it would
                                                               other hostile acts when          probably be self-financing
                                                               commercial insurance is          from premiums for
                                                               unavailable on reasonable        assumption of anticipated
                                                               terms and conditions and         risks.
                                                               continued service is in the
                                                               interest of U.S. policy.
                                 National Flood Insurance      Insures buildings and       Yes; implicit subsidy by
                                                               contents against losses due statutory design.
                                                               to flooding in communities
                                                               nationwide that enact and
                                                               enforce appropriate flood
                                                               plain management
                                                               measures.
                                 National Credit Union Share   Insures member shares            Intent unclear; deposits
                                 Insurance                     (deposits) at credit unions      backed by the full faith and
                                                               against losses in the event      credit of the U.S.
                                                               of insolvency.                   government.
                                                                                                                 (continued)


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                                                                                                 Statutory intent for
                      Program                               Description                          government subsidy
                      OPIC’s Political Risk                 Insures the investments of           No; statutory intention for
                      Insurance                             U.S. companies in                    self-financing but
                                                            developing countries                 guaranteed by the full faith
                                                            against several political            and credit of the U.S.
                                                            risks, including                     government.
                                                            expropriation, currency
                                                            inconvertibility, and political
                                                            violence.
                      PBGC’s Pension Insurance              Insures retirement benefits          No; statutory intent for
                                                            of workers and beneficiaries         self-financing from
                                                            covered by private sector            premiums paid by
                                                            defined benefit pension              employers on behalf of their
                                                            plans.                               employees.
                      Savings Association Deposit           Insures deposits at savings          Intent unclear; deposits
                      Insurance                             and loans and savings                backed by the full faith and
                                                            banks against losses in the          credit of the U.S.
                                                            event of insolvency.                 government.
                      Service-Disabled Veterans             Provides life insurance to           Yes.
                      Insurance                             veterans with
                                                            service-connected
                                                            disabilities.
                      National Vaccine Injury               Provides compensation for            No.
                      Compensation                          vaccine-related injury and
                                                            death.
                      Veterans Mortgage Life                Provides life insurance to Yes.
                      Insurance                             disabled veterans who have
                                                            received grants for
                                                            specially-adapted housing.


                      The budget treatment of federal insurance programs is complicated by the
Characteristics of    characteristics of the risks covered. In general, these programs assume
Federal Insurance     risks that the private sector has historically been unable or unwilling to
Programs Complicate   undertake. Ideally, individual risks should be independent and of sufficient
                      number to reasonably project losses and adequately pool risk2 to be
Budget Treatment      insurable. In addition, the occurrence of losses should be accidental or
                      unintentional in nature and capable of being measured.3 Many of the risks
                      undertaken by the federal government lack these key conditions for ideal
                      insurability. Without these insurable conditions, establishing an actuarially




                      2
                       Pooling risk refers to the spreading of risk among a large number of insureds in order to reduce the
                      cost of bearing the risk.
                      3
                      Additional factors, such as the ability to diversify risk, are likely to affect the private sector’s
                      willingness to provide certain types of coverage.



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sound rate structure is difficult and the likelihood of adverse selection4
and moral hazard increases.5 From a federal budget perspective, the lack
of these insurable conditions presents significant challenges.

The risks insured by the government are often hard to predict and
catastrophic in size. In general, the lack of an actuarial base,6 an
ever-changing environment, and low participation rates make it difficult to
assess risk assumed and set premiums commensurate with the risk
insured. For example, officials at the Overseas Private Investment
Corporation (OPIC) cited the lack of an actuarial base as a factor in the
limited availability of private sector political risk insurance.7 Further,
some risks assumed by the federal government are not independent in that
losses may strike a large number of insureds at the same time. For
example, weather-related events may reduce crop yields over large areas
of the nation in the same year. Similarly, changes in macroeconomic
conditions may have widespread effects on banks and pension plans
covered under the deposit and pension insurance programs.

Achieving adequate participation to spread risks may also be problematic.
For example, our previous work found that the majority of federal crop
insurance policies are in the contiguous areas of the Midwest and the
Plains States.8 Similarly, those living in concentrated areas with the
greatest risk of flooding are most likely to buy flood insurance while those
with lower risk are not. Finally, according to agency officials, the war-risk
and political risk insurance programs provide only a limited number of
policies covering diverse events with strong individual and case-specific
identities.

The catastrophic nature of these risks and the impediments to broad-based
participation reduce the ability of an insurer to pool risk—an important
way insurers reduce the costs of bearing risk. When insured events affect a


4
 Adverse selection is the tendency for those with the highest probability of loss to purchase insurance
and those with the least risk of loss to opt not to purchase insurance.
5
 Moral hazard is the incentive for those insured to undertake greater risk than if they were uninsured
because the negative consequences of such actions are passed through to the insurer. For example, in
the 1980s when government regulators allowed thrifts to remain open with low levels of capital, the
temptation of moral hazard was increased. Thrifts with nearly depleted capital had little to lose by
making very risky loans in the hope of large profits.
6
 An actuarial base is an historical pattern of insured events under similar conditions that is of
sufficient number to reasonably project losses and pool risks.
7
 For a description of political risk insurance, see appendix IV.
8
 Crop Insurance: Additional Actions Could Further Improve Program’s Financial Condition
(GAO/RCED-95-269, September 28, 1995).


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                        large number of the insured population at the same time, the likelihood
                        that the insurer would have to make large claim payments in a relatively
                        short period of time increases. When there are only a few insured, the
                        insurer is unable to pool risk and thus may be subject to virtually the same
                        uncertainties of random experience as the insured.

                        OMB has cited the government’s size and sovereign power as providing it
                        with the unique ability to offer insurance when the private market is
                        unable or unwilling to do so. Some analysts contend that the size of the
                        government makes it better able to absorb large losses if insurance
                        reserves are not sufficient. Over time, by providing ongoing insurance, the
                        government may be able to recoup some of these losses with future
                        premium collections, thus in effect pooling risks over time. In addition, the
                        government can attempt to spread the cost of these risks by providing
                        insurance nationwide and/or mandating participation. Further, some
                        analysts cited the government’s unique status as advantageous in
                        monitoring and mitigating these types of risks. For example, for a
                        community to participate in the flood insurance program, it must enact
                        and enforce minimum flood plain management standards. Similarly,
                        federally insured banks and thrift institutions must adhere to numerous
                        regulations and periodic examinations.

                        Whatever the merits of the federal government as an insurer, the same
                        characteristics that inhibit private insurance firms from covering these
                        risks also complicate budgeting for them at the federal level. In some
                        cases, the volatile and/or catastrophic nature of the insured risks make
                        pooling risk and estimating claims on an annual basis difficult, if not
                        impossible. For some programs, such as life and pension insurance, claims
                        may not be expected to occur for years or even decades after the
                        government’s commitment is made. Thus, a key budget consideration is
                        how and when the government’s costs for these programs should be
                        recognized in the budget.


                        As a general principle, decision-making is best informed if the government
Key Information for     recognizes the costs of its commitments at the time it makes them.
Budget                  However, despite numerous financial measures, in most cases, the
Decision-making—        expected cost of the government’s insurance commitments is not readily
                        available. Table 2.2 provides several financial measures for the programs
the Risk Assumed by     in our study including face value, net outlays, liability for claims, and net
the Government—Is       position. As discussed in the following sections, each of these measures
                        provides useful information but, in most cases, does not adequately
Not Readily Available

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                                         capture and isolate the cost of the risk assumed by the federal government
                                         at the time the insurance is extended. However, to the extent practicable,
                                         the government’s ultimate cost is key information that ought to be
                                         considered in making budget decisions.


Table 2.2: Federal Insurance Programs
Dollars in millions
                                      Face valuea                   Net outlaysa             Claims liabilityb             Net positionb
Program                           Fiscal year 1995              Fiscal year 1995          September 30, 1995          September 30, 1995
Aviation War-Risk Insurance                    2,000                             –2                             0a                        60a
Bank Deposit Insurance                  1,919,000                             –6,916                          493                  25,454
National Credit Union Share                  266,000                           –297                           122                    3,250
Insurance
Federal Crop Insurance                        26,000                            387                          1,237                       915
Federal Employees’ Group                     353,000                           –916                         20,090                 –3,472
Life Insurance
Maritime War-Risk Insurance                    2,000                             –2                             0a                        24a
National Flood Insurance                     325,000                            459                           162                  –1,027
                                                      c
OPIC’s Political Risk                         21,300                           –208                            79                    2,462d
Insurance
PBGC’s Pension Insurance                     853,000                           –430                         10,398                   –123
Savings Association                          709,000                          –1,101                          111                    3,358
Deposit Insurance
Service-Disabled Veterans                      1,500                             62                           516a                   –463a
Insurance
National Vaccine Injury                          700                             51                           n.a.e                      945a
Compensation
Veterans Mortgage Life                           200                            n.a.e                         n.a.e                      n.a.e
Insurance
                                         a
                                          Budget of the United States Government, Fiscal Year 1997 and OMB. GAO did not
                                         independently verify.
                                         b
                                             Agency audited financial statements, unless otherwise noted.
                                         c
                                          Under most outstanding insurance contracts, investors and lenders may obtain three different
                                         types of insurance coverage, but aggregate claim payments may not exceed the single highest
                                         coverage amount. In addition, face value includes a provision for standby coverage for which
                                         OPIC is currently not at risk. OPIC calculated its “Current Exposure to Claims” for 1995 as
                                         $6.6 billion.
                                         d
                                             Capital and retained earnings.
                                         e
                                          Not available.




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                                          Face value represents the total amount of insurance outstanding. For
                                          example, the face value of deposit insurance is the total insured deposits
                                          held by financial institutions. As such, it provides a measure of the
                                          maximum exposure undertaken by the federal government. As shown in
                                          figure 2.1 and table 2.3, the face value of federal insurance (in constant
                                          dollars) grew substantially between 1975 and 1990. The majority of this
                                          increase is attributable to the two largest insurance programs, pension and
                                          deposit insurance. For fiscal year 1995, the estimated face value of major
                                          federal insurance programs was approximately $5 trillion—more than half




                                    
                                     ,,,,,
                                          of which was deposit insurance. Figure 2.1 shows the trend in the face
                                          value of major federal insurance programs.


Figure 2.1: Face Value of Major Federal
Insurance Programs by Type                 6000     Constant 1995 dollars in billions




                                    
                                    
                                     ,,,,,
                                     
                                           5000



                                           4000



                                           3000



                                           2000



                                           1000




                                       ,
                                              0
                                               1970                 1975                 1980            1985                1990      1995


                                                               Deposit insurance                       Other insurance

                                                              Life insurance                           War-risk insurance

                                                              Disaster insurance                       Pension benefit insurance




                                          While face value provides one measure of program size, it overstates the
                                          potential cost to the government. The probable cost to the government is
                                          most likely some percentage of the total face value. However, a single
                                          fixed percentage cannot be used as a proxy for exposure since the



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                                         government’s risk varies based on a variety of factors, such as the nature
                                         of insured risk and the extent to which premium collections offset costs.
                                         Thus, a self-supporting insurance program with a relatively high face value
                                         may have a lower potential cost to the government than a subsidized
                                         insurance program with lower face value.

Table 2.3: Face Value of Major Federal
Insurance Programs                       Dollars in billions
                                                                                        Constant fiscal year 1995 dollars
                                         Program                              1970        1975       1980        1985       1990         1995
                                         Federal Deposit Insurance          1,707.2     2,256.7    2,637.0     3,212.6    3,250.5     2,894.0
                                                                                    b
                                         Pension Benefit Guaranty                          n.a.      734.6      820.4     1,008.1        853.0
                                         Corporationa
                                         National Flood Insurance               n.a.      36.2       160.3      183.5       234.9        325.0
                                         Federal Crop Insurance                 2.9         3.2        4.9         9.1       14.8         26.0
                                         Aviation War-Risk Insurance          190.3      125.9       335.1      251.0       547.5          2.0c
                                         Maritime War-Risk Insurance           60.9       66.0        39.3        n.a.       12.7          2.0c
                                                                    d
                                         Veterans Life Insurance              319.0      273.1       191.1      212.6       247.6        490.1
                                         Federal Employees’ Group             141.2      157.5       136.6      273.0       318.7        353.0
                                         Life Insurance
                                         Overseas Private                      28.0e      15.3         9.8       15.1        11.4         21.3
                                         Investment Corporation
                                                                                    b          b           b          b
                                         National Vaccine Injury                                                              n.a.         0.7
                                         Compensationf
                                                                                                                                  b           b
                                         Nuclear Risk Insurance               358.4      154.4       162.1       96.7
                                         Total insurance in force           2,807.9     3,088.3    4,410.8     5,074.0    5,646.2     4,967.1
                                         Source: OMB data adjusted for inflation. GAO did not independently verify.
                                         a
                                             Established in 1974.
                                         b
                                             Not in existence.
                                         c
                                          Methodology for calculating face value changed in 1995 to more realistically reflect program
                                         operation.
                                         d
                                          Includes all veterans’ life insurance programs. Only the Service-Disabled Veterans Life Insurance
                                         program and the Veterans Mortgage Life Insurance program are included in our study.
                                         e
                                          Includes insurance issued by the Agency for International Development (AID). The Foreign
                                         Assistance Act of 1969 established OPIC and transferred AID’s insurance and credit programs to
                                         OPIC.
                                         f
                                         Program established in 1986.



                                         Other financial measures may also be of limited help in assessing the cost
                                         of the risk assumed by the government at the time the insurance



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                      commitment is extended. For example, the outlays recorded in the
                      President’s budget provide a measure of an insurance program’s estimated
                      and actual annual cash flows but, in most cases, does not capture the
                      government’s cost of insurance commitments at the time they are
                      extended. In addition, cash outlays may be subject to significant volatility
                      due to the irregular and catastrophic nature of some insured risks, such as
                      natural disasters. Chapter 3 discusses in detail the shortcomings of the
                      current cash-based budget reporting for federal insurance programs.

                      Further, while the claims liability and net position reported in the financial
                      statements for federal insurance programs provide useful measures of the
                      programs’ financial condition based on insured events that have occurred,
                      these measures do not, in most cases, capture the expected cost of claims
                      inherent in the government’s commitment. In general, the financial
                      statement liability is an estimate of the amount needed to settle unpaid
                      and expected claims related to insured events that have occurred on or
                      before the reporting date. Net position is the difference between an
                      entity’s assets and liabilities. The Federal Accounting Standards Advisory
                      Board (FASAB)9 recently developed standards calling for the supplemental
                      disclosure of estimates of the risk assumed by the federal government for
                      its insurance programs. This action, which is discussed in greater detail in
                      chapter 4, will help improve information on these costs.


                      All the federal insurance programs reviewed record collections and
Snapshot of Current   payments in net outlays on a cash basis and thus influence the deficit in
Budget Treatment      the year cash flows occur, regardless of when the commitments are made.
                      With one exception,10 the premiums and fees paid by participants are held
                      in revolving funds—trust or public enterprise—and, in most cases,
                      administrative expenses are also paid out of these funds. To the extent
                      that the budget authority in these funds exceeds current cash outlay needs
                      and remains available for future claims, most insurance programs have
                      some level of reserves. Six of the 13 programs have permanent borrowing
                      authority to cover the cost of claims, and 4 have received general fund
                      appropriations within the last 10 years to pay claims in excess of available
                      resources.



                      9
                       FASAB was established in October 1990 by the Secretary of the Treasury, the Director of the Office of
                      Management and Budget, and the Comptroller General. The nine-member Board was created to
                      consider and recommend accounting principles for the federal government.
                      10
                       Veterans Mortgage Life Insurance is included in the Veterans Insurance and Indemnities account,
                      which is a general fund account.



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Budgetary characteristics, such as the classification of a program’s
spending under the Budget Enforcement Act of 1990 (BEA),11 will affect the
extent to which an accrual-based approach would change the information
and incentives provided to policymakers. An examination of the programs
included in our study shows that the majority are classified as mandatory12
spending under BEA. Claim payments for only 3 of the 13
programs—Aviation War-Risk Insurance, Maritime War-Risk Insurance,
and OPIC’s political risk insurance—are classified as discretionary
spending.13 Table 2.4 summarizes key budget information for the insurance
programs reviewed.

The programs also differ in the extent to which costs are currently
recognized in budget authority and obligated based on accrual concepts.14
For example, two programs—the Federal Crop Insurance Program and
OPIC’s political risk insurance program—currently obligate budget reserves
based on accrual concepts. According to OMB, the crop insurance program
obligates funds based on an estimate of claims incurred or expected to be
incurred for outstanding policies at the end of the fiscal year. OPIC
currently obligates budget reserves for its insurance program based on an
estimate of the losses inherent in insurance outstanding.




11
  Title XIII of Public Law 101-508.
12
  Under BEA, mandatory spending (also known as direct spending) is subject to pay-as-you-go
(PAYGO) provisions. PAYGO provisions do not set limits on mandatory spending but rather control
the enactment of new authorizing legislation for mandatory spending. Under PAYGO provisions,
legislation enacted during a session of the Congress that increase mandatory spending or decrease
revenues must be at least deficit neutral in the aggregate. Deposit insurance spending was specifically
exempted from PAYGO restrictions.
13
 The aviation and maritime war-risk programs have permanent authority to spend offsetting
collections.
14
 Under some accrual-based budgeting approaches, expected costs would be recorded in budget
authority and obligated when the insurance is extended. (See chapter 6.)



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Table 2.4: Budget Information for
Major Federal Insurance Programs                                                           BEA classification
                                    Program                                    Claim payments      Administrative costs
                                    Bank                                       Mandatory           Mandatory
                                    Deposit Insurance
                                    Savings Association                        Mandatory           Mandatory
                                    Deposit Insurance
                                    National Credit Union                      Mandatory           Mandatory
                                    Share Insurance
                                    PBGC’s                                     Mandatory           Mandatory
                                    Pension Insurance
                                    National Flood                             Mandatory           Discretionary
                                    Insurance
                                    Federal Crop                               Mandatory           Discretionaryb
                                    Insurance
                                    Aviation                                   Discretionary       Discretionary
                                    War-Risk Insurance
                                    Maritime                                   Discretionary       Discretionary
                                    War-Risk Insurance
                                    Service-Disabled                           Mandatory           Mandatory
                                    Veterans Insurance
                                    Veterans Mortgage                          Mandatory           Mandatory
                                    Life Insurance
                                    Federal Employees’                         Mandatory           Mandatory
                                    Group Life Insurance
                                    OPIC’s Political                           Discretionary       Discretionary
                                    Risk Insurance
                                    National Vaccine Injury Compensation       Mandatory           Mandatory,
                                                                                                   Discretionary




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                                                                                      General appropriations
Fund type           Sources of financing                                              in last 10 years       Borrowing authority
Public enterprise   Premiums, recovery of assets acquired in receivership,            No                                $30 billion
                    deposit assumption transactions, and interest earnings
Public enterprise   Premiums, recovery of assets acquired in receivership,            Yes                               $30 billion
                    deposit assumption transactions, and interest earnings
Public enterprise   Premiums, interest earnings, and 1-percent deposit from           No                                $100 million
                    insured credit unions
Public enterprise   Premiums, assets from terminated plans, and investment            No                                $100 million
                    income
Public enterprise   Premiums, collection of program expenses, and interest            No                                $1 billiona
                    earnings
Public enterprise   Premiums and appropriationsc                                      Yes                               No

Public enterprise   Premiums, interest earnings, and one-time registration fees No                                      No
                    for nonpremium insurance
Public enterprise   Premiums, interest earnings, binder fees, and claim               No                                No
                    reimbursements
Public enterprise   Premiums, interest on policy loans, policy loan repayments, Yes                                     No
                    and appropriations
General             Premiums, interest on policy loans, policy loan repayments, Yes                                     No
                    and appropriations
Trust               Premiums and interest earnings                                    No                                No

Public enterprise   Premiums, insurance claim recoveries, and interest                No                                $100 million
                    earnings
Trust               Excise tax on manufacturers and interest earnings                 No                                No


                                         a
                                         For fiscal year 1997 only, the program is authorized to borrow $1.5 billion.
                                         b
                                           Before fiscal year 1994, administrative and operating expenses were classified as discretionary
                                         spending. Under the 1994 crop insurance reforms, these expenses were classified as mandatory
                                         for fiscal year 1995 and fiscal year 1996 and discretionary spending for fiscal year 1997.
                                         However, the most recent Freedom to Farm legislation classifies these expenses as mandatory for
                                         fiscal year 1997 and then splits them between mandatory and discretionary for the years
                                         thereafter.
                                         c
                                          The Federal Crop Insurance Corporation is authorized under the Federal Crop Insurance Act, as
                                         amended, to use funds from the issuance of capital stock, which provides working capital for the
                                         corporation.




                                         Page 43                            GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Chapter 3

A Budget Perspective on Federal Insurance


                     Budget reporting influences decision-making because it determines how
                     critical choices are framed and how the deficit is measured. The method of
                     budget reporting reflects choices about the uses and functions of the
                     federal budget. Ideally, budget reporting should fully inform resource
                     allocation and fiscal policy choices. Unfortunately, the current budget’s
                     focus on annual cash flows provides potentially incomplete and
                     misleading information on the cost of federal insurance programs. As a
                     result, the information and incentives for sound resource allocation
                     decisions and information on the timing and magnitude of the economic
                     impact of these programs may be distorted. However, the impact of these
                     shortcomings on budget decision-making varies significantly across the
                     federal insurance programs we reviewed.


                     In practice, the federal budget serves multiple functions. The budget is
Budget Reporting     used to plan and control resources, assess and guide fiscal policy, measure
Reflects Choices     the government’s borrowing needs, and communicate the government’s
About the Uses and   policies and priorities. The budget is both an internal management tool of
                     the government and a public policy statement. The many uses of the
Functions of the     budget lead to multiple and often conflicting objectives for budget
Budget               reporting. For example, the budget should be understandable to
                     policymakers and the public yet comprehensive enough to fully inform
                     resource allocation decisions. Since no one method of budgetary reporting
                     can fully satisfy all uses, the choice ultimately reflects a prioritization of
                     the budget’s various uses.

                     The method of budget reporting influences decision-making because the
                     way budget transactions are recorded determines how critical choices are
                     framed and how the deficit is measured. For example, suppose the federal
                     government extends insurance for which it collects $1 million in premiums
                     and expects total losses of $3 million to be incurred in future years. If the
                     primary objective of the budget is to track annual cash flows, then it is
                     appropriate to record the $1 million cash inflow and to offset the
                     aggregate deficit accordingly, as is currently the case. However, if the
                     objective is to provide information on the government’s cost when
                     program decisions are made then it is appropriate to recognize a net cost
                     of the present value of $2 million in the year the insurance is extended.
                     Clearly, the two methods of reporting provide policymakers with very
                     different information and so may affect budget choices differently. While
                     both methods provide useful information and can be tracked




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                          simultaneously, only one can be the primary basis upon which budget
                          decisions are made.1


Budget Reporting Should   An essential step in assessing the adequacy of a program’s budget
Fully Inform Resource     treatment is determining the information necessary for sound
Allocation and Fiscal     decision-making. Although the federal budget has multiple functions, it is
                          generally recognized that the allocation of resources and measure of fiscal
Policy Decisions          policy are primary. In 1967, the President’s Commission on Budget
                          Concepts first identified resource allocation and fiscal policy as the
                          primary purposes of the budget.2 In doing so, the Commission
                          acknowledged that no one method of budget reporting can adequately
                          serve all possible purposes of the budget or all users’ needs but concluded
                          that these other uses were subordinate to the needs of resource allocation
                          and fiscal policy. The Commission reported that

                          Of the various purposes for which the President’s budget is prepared, two closely related
                          purposes outweigh the rest. . . . In short, the budget must serve simultaneously as an aid in
                          decisions about the efficient allocation of resources among competing claims and
                          economic stabilization and growth.3


                          Our assessment of the budget treatment of federal insurance programs
                          focuses on the adequacy of budget information for resource allocation and
                          fiscal policy. However, to support these purposes, budget reporting must
                          be understandable and provide for budget control and accountability.4 As
                          a result, implementation issues, such as estimation uncertainties and
                          reporting complexities, may offset or even negate the potential benefits of
                          some changes that would seem to support resource allocation and fiscal
                          policy decisions. That is, decisions on budget treatment must balance the
                          ideal of better information with the realities of implementation.

                          Information on the cost of the government’s commitments is vital for
                          sound resource allocation decisions. In an environment of limited




                          1
                          For additional discussion, see Budgetary Treatment of Deposit Insurance: A Framework for Reform,
                          May 1991, Congress of the United States, Congressional Budget Office.
                          2
                            Report of the President’s Commission on Budget Concepts, President’s Commission on Budget
                          Concepts, U.S. Government Printing Office, October 1967.
                          3
                           Ibid., p.12.
                          4
                           For additional information on the objectives of the budget process, see Budget Process: History and
                          Future Directions (GAO/T-AIMD-95-214, July 13, 1995).



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resources, decisions are based on the relative budgetary cost5 of each
potential use. To permit fully informed choices and provide for budget
control, the cost for each alternative use of federal resources must be
clear and directly related to the commitments undertaken by the
government. Full cost information in the budget not only allows
policymakers to make relative cost comparisons but can also warn of
estimated increases in costs when they are still controllable. To do this,
budget reporting ideally would provide reliable information on the cost of
commitments made in a given year. However, in practice, there is often no
clear bright line at which this commitment point is made for any particular
program.

For federal insurance programs, key information relevant to policymakers
is the balance between collections and costs over time flowing from a
commitment. Amounts not covered by program collections represent the
government’s subsidy cost for the program. Because of the wide variety of
risks covered by different federal insurance programs, the application of
the risk-assumed concept is likely to differ depending on the nature of the
program. For example, the extent to which a model can capture the full
long-term expected cost of the government’s deposit insurance
commitments, including rare catastrophic events such as the savings and
loan crisis, is open to debate.

Fiscal policy decisions require information on the timing and magnitude of
the economic impact of the government’s actions. Economic impact is
generally considered to be the impact on aggregate demand and the
allocation of resources between private and public markets. In general, the
budget deficit (or surplus) is considered to be an appropriate measure of
the macroeconomic impact of aggregate federal fiscal policy on the
economy and for most programs cash-based reporting adequately captures
the fiscal impact of budget decisions. However, for insurance programs
cash-based reporting may misstate the economic impact of the
government subsidy by recording cost when cash flows occur rather than
when the insurance commitment is made. Although discerning the
economic impact of insurance programs can be difficult, private economic
behavior generally is affected when the government commits to providing
insurance coverage and thus lowers the risk to the insureds. Therefore, to
fully inform decision-making, the budget recognition of an activity’s
expected costs ideally should coincide with the timing and magnitude of
its economic effects. Similarly, financial transactions that have no impact

5
 Relative budgetary cost refers to the cost recorded in the budget for one federal program in relation to
another. To the extent that the method of budget reporting does not measure program costs on a
comparable basis, relative costs and thus resource allocation decisions will be distorted.



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                                 on the cost to the government—such as temporary working capital
                                 needs—should not be recognized in the budget.


                                 In general, the information provided by cash-based budgeting for federal
Cash-Based Budgeting             insurance programs may be incomplete or misleading for both resource
Generally Provides               allocation and fiscal policy decisions. In most cases, the cash-based budget
Incomplete                       does not adequately reflect on a timely basis either the government’s cost
                                 or the economic impact of these programs because costs are recognized
Information on                   when claims are paid rather than when the commitment is made and when
Federal Insurance                economic behavior is generally changed. Thus, the budget may provide
                                 neither complete cost information for budget decision-making nor the
Programs                         incentives necessary to control costs or ensure that adequate resources
                                 are available for future claims at the time the decision to extend the
                                 insurance is made.

                                 In general, cash-based budgeting for insurance programs presents several
                                 problems. In most instances, it focuses on single period cash flows that
                                 may distort the program’s cost to the government and thus may

                             •   distort the information and incentives for resource allocation decisions,
                             •   not accurately reflect the program’s economic impact, and
                             •   cause deficit fluctuations unrelated to long-term fiscal balance.

                                 However, the magnitude of this problem and the implications for budget
                                 decision-making vary significantly across the insurance programs. This is
                                 due primarily to differences in the size and length of the government’s
                                 commitment, the nature of the insured risk, and the extent to which costs
                                 are currently recognized in the budget at the time decisions are made.


Single Period Cash Flows         With limited exceptions, current budget reporting focuses on annual cash
Distort the Government’s         flows. Collections for insurance programs are recorded in the budget
Cost for Federal Insurance       when received and costs are recorded in outlays and the deficit when
                                 claims are paid. Yet the focus on annual cash flows may not adequately
Programs                         reflect the government’s cost for federal insurance programs because the
                                 time between the extension of the insurance, the receipt of program
                                 collections, the occurrence of an insured event, and the payment of claims
                                 may extend over several budget periods. As a result, the government’s cost
                                 may be understated in years that a program’s current collections exceed
                                 current payments and overstated in years that current claim payments




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exceed current collections. These distortions occur even if the collections
and payments for an insurance commitment balance over time.

The timing differences between an insurance activity’s collections and
payments on a cash basis are complicated by combining, in a single
account, transactions that represent a cost to the government and
transactions that merely represent cash flows that net out over time. A key
feature of credit reform was the separation of the government’s cost,
called the subsidy cost, from unsubsidized program costs. Similarly,
federal insurance programs that do not set premiums high enough to cover
expected future claims represent a cost to the government. Claim
payments to the extent covered by collections and temporary
transactions,6 such as the acquisition and sale of assets obtained in
settlements, are examples of cash flows that over time, do not impose a
cost to the government. However, since the current budget treatment
focuses on annual cash flows rather than a program’s long-term financial
balance, the cost to the government—the key information that should be
used in budget decision-making—may be obscured. The cost of current
decisions is further obscured because single period cash flows often
reflect a mix of old and new insurance business.

As shown in table 3.1, the timing differences between cash flows for
insurance programs occur for several reasons that vary across the
programs. The length of the government’s commitment (policy duration)
or the time between the occurrence of an insured event and the payment
of claims (the claim settlement period) may extend over several years. In
addition, erratic cash flows may result from temporary (working capital)
transactions or from the nature and timing of insured events. The different
reasons for the time lags between collections and payments among the
various insurance programs are important because they influence both the
extent to which cash-based budgeting is a deficient measure of program
costs and the effectiveness of alternative accrual cost measures in
overcoming these deficiencies.




6
 For purposes of this report, temporary transactions are defined as transactions that result in
offsetting cash flows that net over time and, consequently, do not impose a cost on the government.



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Table 3.1: Reasons for Mismatch Between Program Collections and Payments
                                                                                                                               Offsetting
                                                                                                 Claim settlement            transactions
                                           Policy duration             Loss pattern          Time between               Cash flows resulting
                                       Government’s               Insured events             insured event and          from offsetting
                                       commitment                 tend to be                 claims payment             transactions such as
                                       extends over several       sporadic or                extends over several       working capital
Program                                years                      catastrophic               budget periods             needs
Aviation War-Risk Insurance                                       X
Deposit Insurance                      X                          X                          Xa                         X
Federal Crop Insurance                                            X
Federal Employees’                     X
Group Life Insurance
Maritime War-Risk Insurance                                       X
National Flood Insurance                                          X
OPIC’s Political Risk Insurance        X                          X                          X
PBGC’s Pension Insurance               X                          X                          X
Service-Disabled Veterans              X
Life Insurance
                                                                  b
National Vaccine Injury Compensation                                                         X
Veterans Mortgage Life Insurance       X
                                            a
                                             Based on the experience in the late 1980s in which financial institutions were allowed to remain
                                            open for months or years after becoming insolvent. Future experience may be different. The
                                            Federal Deposit Insurance Corporation Improvement Act of 1991 requires the prompt closure of
                                            severely undercapitalized financial institutions.
                                            b
                                             Program information insufficient to determine claim pattern.



                                            A mismatch between collections and payments may occur when the
                                            government’s commitment extends over multiple years or budget periods.
                                            As table 3.1 shows, several federal insurance programs—those offering
                                            multiyear fixed term, renewable term, or noncancelable
                                            coverage—commit the government for extended periods. For example,
                                            OPIC provides multiyear political risk coverage for up to 20 years. In
                                            addition, some budget and financial experts view PBGC’s pension guarantee
                                            as a long-term, renewable, or noncancelable commitment. In all these
                                            cases, the extension of the insurance and the collection of premiums may
                                            occur years, even decades, before the insured event occurs and claim
                                            payments come due. As a result, there can be years in which an insurance
                                            program’s current cash collections are estimated to exceed current cash
                                            payments, and the program appears to be profitable regardless of its
                                            expected long-term cost to the government.




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Time lags between the occurrence of an insured event and the payment of
claims may also result in a mismatch between collections and payments.
While some insurance programs pay claims within one or two budget
cycles, several do not. For example, during the savings and loan crisis, a
number of factors, such as inadequate regulatory oversight and the
insurance fund’s lack of cash, delayed action to close failed institutions
and pay depositors. A different set of factors create a delay in the pension
guarantee program. Benefit payments of terminated plans assumed by the
PBGC may not be made for years, even decades, because plan participants
generally are not eligible to receive pension benefits until they reach age
65. Once eligible, these benefits are paid over a period of years or even
decades. Payment of claim awards under the Vaccine Injury Compensation
Program (VICP) may not be made for several years after the injury occurs
or not at all. The total time lag is the sum of (1) the time between the
occurrence of the adverse event and the filing of a petition for payment,
(2) the time taken to reach a judicial decision with respect to the petition,
and (3) the time between the decision to grant an award and payment. As
of May 1994, the average time between vaccination and payment for VICP
cases arising from 1989 vaccinations was 1,053 days.

In some cases, temporary transactions that occur over time may impede
the proper matching of insurance collections and payments on a cash
basis. During the savings and loan crisis, large temporary cash flows
(working capital) resulting from the acquisition and sale of assets from
failed institutions distorted the government’s cost for deposit insurance in
the cash-based budget. In years that assets were acquired, the full amount
of cash required was recorded as an outlay; later, when the assets were
sold, the proceeds were recorded as income. As a result, the cash-based
budget overstated the cost of the deposit insurance in some years and
understated it others.

The catastrophic or uneven occurrence of some insured events also
increases the difficulty in achieving the proper matching of insurance
collections and payments on an annual cash flow basis. The focus on
annual cash flows generally is not compatible with budgeting for these
types of events because it is difficult to estimate the occurrence of the
insured events and pool risk on an annual basis. This is true even when it
is possible to estimate the long-term expected cost of the program. For
example, while it is possible to estimate with a fair degree of accuracy the
probability that floods will occur over a considerable number of years,
predicting the timing and magnitude of any particular flood by more than a
few days is considered impossible. Thus, even if long-term flood losses are



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                                correctly estimated, losses in a considerable number of years may deviate
                                significantly from the long-term average.7 This means that in some years
                                cash flows shown in the budget may neither adequately reflect the
                                program’s cost to the government nor recognize the need to establish
                                reserves over time to cover costs in high-loss years.


Failure to Reflect the          When insurance costs measured on an annual net cash flow basis do not
Government’s Cost               capture the cost of the government’s insurance commitments,
Distorts the Budget             policymakers may be basing decisions on incomplete or misleading
                                information. The failure to isolate and recognize the government’s
Information and Incentives      cost—the key information that should be used for resource allocation—at
Necessary for Sound             the time decisions are made can have significant implications. Generally
Resource Allocation             speaking, cash-based budgeting for federal insurance programs may
Decisions                       provide neither the information nor incentives necessary to signal
                                emerging problems, make adequate cost comparisons, control costs, or
                                ensure the availability of resources to pay future claims.

Cash-Based Budgeting Neither    In most cases, the cash-based budget does not prompt decisionmakers to
Provides Complete Cost          consider an insurance program’s actuarial soundness.8 When costs are not
Information When Decisions      recognized and fully funded in the budget, policymakers may not receive
Are Made Nor Signals Emerging   adequate information on a program’s relative budgetary cost or incentives
Problems                        to address emerging problems. As a result, the government’s subsidy costs
                                may be obscured until claim payments come due.

                                For example, the National Flood Insurance Program (NFIP) provides
                                subsidized coverage without triggering recognition of potential subsidy
                                costs to the government. Under current policy, the Congress has
                                authorized the Federal Insurance Administration (FIA) to subsidize a
                                significant portion (approximately 38 percent) of the total policies in force
                                without providing annual appropriations to cover these subsidies.
                                Although FIA has been self-supporting since the mid-1980s—either paying
                                claims from premiums or borrowing and repaying funds to the
                                Treasury—the program has not been able to establish sufficient reserves
                                to cover catastrophic losses9 and, therefore, cannot be considered

                                7
                                 Insurance and Other Programs for Financial Assistance to Flood Victims: A Report from the Secretary
                                of the Department of Housing and Urban Development to the President, as Required by the Southeast
                                Hurricane Disaster Relief Act of 1965, Senate Committee on Banking and Currency, 89th Congress, 2nd
                                Session, September 1966.
                                8
                                 In order to be actuarially sound, a program’s funding would need to be sufficient to cover expected
                                future payments for claims and administrative expenses.
                                9
                                 The Federal Insurance Administration estimates that a catastrophic loss year resulting in $3 billion to
                                $4 billion in claim losses has a 1 in 1,000 chance of occurring each year.



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actuarially sound. Similarly, the two veteran’s life insurance programs
included in our study—Service-Disabled Veterans Insurance (SDVI) and
Veterans Mortgage Life Insurance (VMLI)—also provide subsidized
coverage without accruing the annual cost of the subsidy in the budget in
the year the coverage is extended.10

The implications of the failure of cash-based budgeting to recognize
potential costs and signal policymakers of emerging problems was most
apparent during the 1980s and early 1990s as the condition of the two
largest federal insurance programs—deposit insurance and pension
insurance—deteriorated while the budget continued to present a favorable
scenario. For decades, the deposit insurance program appeared to provide
an efficient and self-financing form of protection. During this period, the
program had positive cash flows and reduced the federal budget deficit.
Yet, in the 1980s and early 1990s, over 1,600 banks and nearly 1,300 thrifts
failed, resulting in direct costs to taxpayers of $125 billion. Although GAO
and others raised concerns about these rapidly growing costs, corrective
actions were delayed. The cash-based budget was slow to recognize the
government’s mounting cost of resolving insolvent institutions because
cash outlays were not required until actions were taken to close them and
protect depositors. These costs had already been incurred by the time they
were disclosed in the budget. Furthermore, the cash-based budget may
have also created an incentive to delay closing insolvent institutions (to
avoid increasing the annual deficit), which increased the government’s
ultimate cost of resolving the crisis. Since the crisis, the condition of the
deposit insurance funds has improved dramatically. Once again, the
deposit insurance programs appear healthy and are generating budgetary
cash income11—approximately $8.4 billion for fiscal year 1996—that offset
the aggregate deficit.

In a similar pattern, the cash-based budget did not signal the deteriorating
financial condition of PBGC. As shown in figure 3.1, the cash-based budget
consistently has reported collections exceeding payments (negative
outlays), while the program’s financial statements, which take into
account the present value of insured benefits the government has
incurred, reported an accumulated deficit.12 For example, in 1981 when

10
  The SDVI and VMLI programs reported accrual-based deficits of $457 million and $93 million,
respectively, as of September 30, 1996.
11
  Budgetary cash income refers to the cash flows shown as negative net outlays in the budget.
12
 The liability includes an estimate for future pension benefits that PBGC is or will be obligated to pay
with respect to trusteed plans and terminated plans pending trusteeship. In addition, it includes an
estimate of the liabilities attributable to plans that are likely to terminate in a future year based on
conditions that exist at the end of the fiscal year.



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                                   the account containing PBGC’s cash flows was put on-budget, the
                                   cash-based budget showed cash income of $29 million while the financial
                                   statements showed an accumulated deficit of about $190 million. Over a
                                   decade later, in fiscal year 1992, the cash-based budget continued to
                                   provide an optimistic picture, showing cash income of $654 million, while
                                   the financial statements reported a larger accumulated deficit of about
                                   $2.4 billion.


Figure 3.1: Budgetary Cash Flows
Versus Accumulated Deficit
                                   Nominal dollars in millions
                                   2,000


                                   1,000


                                       0


                                   -1,000


                                   -2,000


                                   -3,000


                                   -4,000


                                   -5,000
                                            81   82    83    84     85    86   87    88     89    90   91   92    93   94   95   96
                                                                                    Fiscal year

                                                                  Budgetary cash income     Accumulated deficit




                                   The cash-based budget has continued to be a poor gauge of PBGC’s
                                   financial condition in recent years. In fiscal year 1996, PBGC reported a
                                   surplus for the first time in its history of $993 million. This surplus
                                   contrasts sharply with the $2.6 billion accumulated deficit reported in
                                   fiscal year 1993. The cash-based budget, however, did not reflect this
                                   turnaround. In fact, cash income reported in the budget during this period
                                   was, on average, lower than in the previous 4 years when PBGC’s financial
                                   condition was deteriorating. Further, despite the improvement in PBGC’s
                                   financial condition, OMB’s more prospective estimate of the program’s
                                   future cost, included in the Analytical Perspectives of the President’s




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Fiscal Year 1997 Budget, ranges from $30 to $60 billion.13 Most important,
if the program’s condition were to worsen in the future, the cash-based
budget may not provide timely warning of the program’s deteriorating
condition.

The Federal Employees’ Group Life Insurance program also demonstrates
the disparity in the signals provided to policymakers from cash basis
versus accrual basis data. For example, in fiscal year 1993, when the
program’s financial condition shifted on an accrual basis from having a
surplus to a deficit, the cash-based budget failed to signal this change in
the program’s financial condition. While the program’s accrual-based net
position shifted from a surplus of about $1.6 billion to a deficit of
$5.8 billion,14 the cash-based budget showed cash income of just over
$1 billion. More recently, the fiscal year 1998 budget year estimates show
cash income of $1.2 billion, while the program’s balance sheet provided in
the budget appendix reveals an increase in the actuarial liability15 of
approximately $1 billion and a deficit of about $3.1 billion.

In addition, the Aviation War-Risk Program appears financially sound on a
cash basis while exposing the government to potentially large unfunded
claims when insurance is in force.16 Despite a current fund balance of
approximately $67 million, the program’s resources may not be sufficient
to cover potential insurance claims. One major loss—such as a Boeing
747-400, which can cost over $100 million—could liquidate all the available
funds and leave a substantial portion of the claim unfunded. If a loss
exceeded the available funds, the Federal Aviation Administration (FAA)
would have to seek supplemental funding to cover the claim.17




13
  Unlike the financial statement liability, OMB’s estimate includes costs resulting from expected future
terminations of underfunded plans sponsored by currently healthy firms.
14
  According to agency officials, an unfunded liability of about $5 billion resulted from an unexpected
increase in the number of enrollees in option B—the most costly option—during an open season for
both basic and optional coverage in fiscal year 1993. The accumulated deficit is based on statutory
reporting requirements, which, according to agency officials, might overstate the program’s liability.
15
  The actuarial liability represents the excess of the present value of estimated benefits to be paid less
the present value of estimated premiums.
16
  The Aviation Program is only activated when commercial insurance is unavailable on reasonable
terms and conditions and continued service is in the interest of U.S. policy. This limited and sporadic
operation may reduce the feasibility of accrual-based budgeting for this program. See appendix IV for a
more detailed description of the program.
17
  For additional information on the Aviation War-Risk Program, see Aviation Insurance: Federal
Insurance Program Needs Improvements to Ensure Success (GAO/RCED-94-151, July 15, 1994).



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Cash-Based Budgeting             Because the cash-based budget delays recognition of emerging problems,
Generally Provides Neither the   it may provide little or no incentive to address potential funding shortfalls
Information Nor the Incentives   before claim payments come due. Policymakers may not be alerted to the
to Control Costs                 need to address programmatic design issues because, in most cases, the
                                 budget does not encourage them to consider the future costs of federal
                                 insurance commitments. Thus, reforms aimed at reducing costs may be
                                 delayed. In most cases, by the time costs are recorded in the budget,
                                 policymakers do not have time to ensure that adequate resources are
                                 accumulated or to take actions to control costs. Delayed recognition of
                                 these costs can reduce the number of viable options available to
                                 policymakers, ultimately increasing the cost to the government.

                                 Further, in some cases, the cash-based budget not only fails to provide
                                 incentives to control costs, it may also create a disincentive for cost
                                 control. Deposit insurance is a key example. Many analysts believe that
                                 the cash-based budget treatment of deposit insurance exacerbated the
                                 saving and loan crisis by creating a disincentive to close failed institutions.
                                 Since costs were not recognized in the budget until cash payments were
                                 made, leaving insolvent institutions open avoided recording outlays in the
                                 budget and raising the annual deficit but ultimately increased the total cost
                                 to the government.

                                 In the past, the cash-based budget treatment and budget scoring rules also
                                 have been cited as creating disincentives for implementing pension
                                 insurance reforms. For example, CBO reported that the Bush
                                 administration’s 1992 program reform proposals would have reduced
                                 PBGC’s funding shortfall and enhanced the financial stability of the
                                 program.18 However, these reforms—specifically the one raising the
                                 minimum contributions required of sponsors of insured pension
                                 plans—would have reduced income tax revenues (because contributions
                                 are tax deductible) and added to the federal deficit in the near term. Thus,
                                 under the pay-as-you-go (PAYGO) provisions of BEA,19 these reforms would
                                 have required reductions in other spending or increases in other revenues.

Failure to Recognize Cost and    To the extent that the cash-based budget fails to capture the cost implicit
Signal Emerging Problems May     in the government’s commitment and signal emerging problems, the
Distort Resource Allocation      relative budgetary costs of an insurance program will be distorted. In some
and Constrain Fiscal Policy      cases, this may simply result in the delayed recognition of intended
                                 choices, but, in other cases, it may lead to unintended resource allocation

                                 18
                                   CBO Testimony, Congressional Budget Office, August 11, 1992.
                                 19
                                  Under PAYGO provisions of BEA, legislation enacted during a session of the Congress that increases
                                 mandatory spending or decreases revenues must be at least deficit neutral in the aggregate.



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                           and fiscal policy. For example, by the time claims come due the
                           government may be faced with little choice but to increase the deficit,
                           raise taxes, or cut other spending in order to honor these commitments.
                           The lack of cost recognition may delay programmatic changes aimed at
                           reducing costs at a point when they are manageable. In summary, the
                           failure to recognize these costs when decisions are made may not only
                           distort current budget choices among competing uses, but may also
                           reduce options for cost control and future budget flexibility when bills
                           come due.


Cash-Based Budgeting May   In addition to not providing sufficient information and incentives for
Not Reflect the Economic   resource allocation, the cash-based budget also may not be a very accurate
Impact of Federal          gauge of the economic impact of federal insurance programs. Although
                           discerning the economic impact of federal insurance programs can be
Insurance Programs         difficult, private economic behavior generally is affected when the
                           government commits to providing insurance coverage. It is at this point
                           that insured individuals or organizations alter their behavior as a result of
                           insurance. However, as noted above, the current cash-based budget
                           records costs not at that point but rather when payments are made to
                           claimants. Federal payments for insurance claims may have little or no
                           macroeconomic effect because these payments generally do not increase
                           the wealth or incomes of the insured. They are merely intended to restore
                           the insured to the approximate financial position he or she would have
                           been in absent the occurrence of the insured event.

                           For example, most analysts agree that the cash-based budget provided
                           misleading information on the timing and magnitude of the economic
                           effects of deposit insurance. A 1992 CBO study of the economic effects of
                           the savings and loan crisis concluded that the economic impact of deposit
                           insurance is more directly related to the accrual of new federal obligations
                           for deposit insurance than to cash payments made under the program.20
                           While federal costs, on an accrual basis, mounted steadily during the 1980s
                           as hundreds of thrift institutions became insolvent, the budget did not
                           record any costs until institutions were closed and depositors paid.
                           Although unrecognized in the budget, these accruing liabilities had
                           economic effects at the time similar to conventional expansionary policy
                           in that aggregate demand was maintained at a higher level than it would




                           20
                             The Economic Effects of the Savings and Loan Crisis, Congressional Budget Office, January 1992.



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                              have been if the depositors had sustained losses.21 Conversely, the budget
                              outlays made to restore saving and loan depositors’ accounts had little
                              effect on overall demand because the wealth or income of depositors was
                              not increased. Further, many analysts have concluded that unlike most
                              spending on other federal programs, the federal borrowing to fund the
                              payments for deposit insurance did not significantly increase interest rates
                              because it did not lead to any increase in the demand for goods or
                              services. Instead, interest rates tended to increase as the government’s
                              deposit insurance liabilities accrued.


Cash-Based Budgeting for      Uneven cash flow patterns of some federal insurance programs can result
Insurance May Produce         in fluctuations in the federal deficit unrelated to the budget’s long-term
Fluctuations in the Federal   fiscal balance. As noted earlier, uneven cash flows may result from both
                              the erratic nature of some insured risks or temporary (working capital)
Deficit Unrelated to          transactions. For example, natural disasters, such as severe floods and
Long-Term Fiscal Balance      droughts, may create spikes in spending patterns that are not indicative of
                              long-term fiscal balance. In addition, the working capital used to resolve
                              failed institutions under the deposit insurance program resulted in large
                              temporary cash flows that distorted the aggregate deficit as a measure of
                              the government’s long-term fiscal imbalance.

                              Insurance programs with long-term commitments, such as PBGC and life
                              insurance programs, also may distort the budget’s long-term fiscal balance
                              by looking like revenue generators and reducing the aggregate deficit in
                              years that collections exceed payments without recognizing the programs’
                              expected costs. On a cash basis, premium income can divert attention
                              from such programs’ financial condition. For example, although the PBGC
                              reforms that were enacted in 1994 as part of the General Agreement on
                              Tariffs and Trade (GATT) legislation will likely improve the financial
                              condition of the program, they were adopted at least in part because on a
                              cash basis they raised revenues. The increase in revenue, primarily
                              resulting from the phase-out of the cap on premiums charged underfunded
                              plans, was necessary under PAYGO budget rules to offset revenue lost from
                              changes in various tariffs affected by the trade agreement. This budget
                              accounting, however, does not recognize that these premiums will be
                              needed to pay PBGC’s costs in the future.




                              21
                                In general, conventional expansionary fiscal policy raises the income of some groups, leading to
                              increased consumption and aggregate demand. Since deposit insurance protects the wealth of
                              depositors in the event of a bank or thrift failure, it increases the consumption of insured depositors
                              and raises overall demand.



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                       While annual cash flows for federal insurance programs generally do not
The Implications of    provide complete information for resource allocation and fiscal policy, the
Cash-Based Budgeting   magnitude of the problem and the implications for budget decision-making
for Decision-making    vary across the insurance programs reviewed. Specifically, the size and
                       length of the government’s commitment, the nature of the insured risk,
Vary Across Programs   and the extent to which these costs are currently captured in cash-based
                       budget estimates influence the degree to which cash-based budgeting is
                       incomplete or misleading for a particular federal insurance program.

                       The size of a program relative to total federal spending and the potential
                       magnitude of unrecognized costs are key factors in judging the severity of
                       the shortcomings of cash-based budgeting. For example, the implications
                       of the shortcomings of the current budget treatment appear greatest for
                       the largest insurance programs, pension and deposit insurance. The large
                       size of these programs means that incomplete or misleading information
                       about their cost could distort resource allocation and fiscal policy
                       significantly, making the limitations of cash-based budgeting more
                       pronounced than for other federal insurance programs.

                       The limitations of cash-based budgeting are most apparent when the
                       government’s commitment extends over a long period of time—e.g., life or
                       pension insurance— and/or the insured events are infrequent or
                       catastrophic in nature, such as severe flooding or depository losses. As
                       discussed earlier, the cash-based budget may not provide timely
                       recognition of the government’s costs for these commitments because of
                       the time lags between the extension of the insurance and the payment of
                       claims as well as the difficulty in estimating and pooling risk on an annual
                       basis. As a result, the cash-based budget may provide misleading or
                       incomplete cost information for extended periods, thus not signaling
                       policymakers of emerging problems when costs are controllable. In these
                       cases, both the direction—positive or negative—and the magnitude of the
                       government’s costs may be distorted on an annual cash flow basis.

                       Conversely, the deficiencies of cash-based budgeting may not be as
                       problematic when the length of the government’s commitment is short and
                       claims occur relatively frequently, such as the occurrence of normal losses
                       under crop and flood insurance programs. In these cases, because the
                       length of time between the government’s commitment and the occurrence
                       and payment of claims is relatively short, the accumulation of
                       unrecognized losses over an extended period of time is less likely.




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In addition, the implications for budget decision-making may be less
severe if relatively frequent claim payments prompt policymakers to
consider the financial condition and funding needs of the program. For
example, some insurance programs, such as flood and crop insurance, use
the average or normal annual loss to make annual budget estimates. Even
so, this approach does not isolate and may not completely capture the
programs’ full costs, including the need to establish reserves for
catastrophic losses. While these estimates provide policymakers some
signals about potential costs at the time decisions are made, the programs’
relative costs may still be understated. For example, in the case of flood
insurance, premiums based on the historical average loss year may not be
sufficient to establish reserves to cover catastrophic losses because the
loss experience period used does not include a catastrophic loss year. As a
result, the program’s cost is understated and the government’s cost may
not be recognized until the bills come due.




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Programs
                     Several characteristics of federal insurance programs support the use of
                     accrual-based budgeting. Two general approaches for measuring
                     accrual-based costs of insurance programs are (1) the risk-assumed
                     concept, which recognizes the cost of claims inherent in the government’s
                     commitment at the time of commitment,1 and (2) traditional financial
                     reporting standards for claims liabilities, which generally recognize the
                     cost of claims inherent in events that have already occurred. The
                     risk-assumed basis would be more useful for budgeting because it looks
                     further ahead at the time the commitment is made rather than waiting for
                     claims-producing events. Thus, the information and incentives for
                     resource allocation and fiscal policy could be improved—assuming it is
                     possible to make reasonable cost estimates. While moving to
                     accrual-based budgeting based on the risk-assumed concept would offer
                     several benefits, the magnitude of the change in information and
                     incentives provided to policymakers varies across insurance programs and
                     depends on the design of the accrual-based budgeting approach used.


                     As discussed in the previous chapters, several characteristics of federal
Characteristics of   insurance programs complicate their budget reporting. In some respects,
Federal Insurance    the difficulties in budgeting for insurance programs are similar to those for
Programs Support     loan guarantees. Both insurance and guarantees commit the government
                     to pay future losses inherent in the coverage provided. Both represent
Use of Accrual       contingent liabilities2 that generally are not adequately reflected on a cash
Concepts             basis because the government’s full cost is not recognized when the
                     commitment is made. While credit reform dealt with this problem for loan
                     guarantees and improved the budget recognition of their cost, the cost of
                     most federal insurance programs is not fully recognized in the budget at
                     the time the insurance commitment is extended.

                     The analogy to credit programs suggests that some form of accrual-based
                     budgeting could improve the budget treatment of federal insurance
                     programs. Specifically, two features of federal insurance programs support
                     the use of accrual-based budgeting for these programs: (1) the promise to
                     cover future losses that may occur beyond the current budget period and
                     (2) the difficulty in estimating and pooling some risks on an annual basis.
                     Accrual-based budgeting would allow for the recognition of future costs at
                     the time commitments are made. However, insurance is dissimilar to loan

                     1
                      As discussed in chapter 7, the extent to which administrative and other operating expenses should be
                     included in the calculation of the risk-assumed accrual cost needs to be determined.
                     2
                      Contingent liabilities are obligations that are dependent upon the occurrence or nonoccurrence of one
                     or more future events.



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guarantees in some ways that present additional challenges for cost
estimation and budget control. These issues need to be dealt with carefully
before accrual-based budgeting can be applied to federal insurance
programs. For example, the benefits of accrual-based budgeting depend
heavily on whether reasonable cost estimates are currently available or
can be developed. In some cases, estimating the risk assumed by
insurance programs may be a greater challenge than for some credit
programs.

Accrual-based reporting recognizes transactions or events when they
occur regardless of when cash flows take place. An important feature of
accrual-based reporting is the matching of expenses and revenues
whenever it is reasonable and practicable to do so. In the case of
insurance, accrual concepts would recognize the cost for future claim
payments and the establishment of reserves to pay those costs. Thus, the
use of accrual concepts in the budget has the potential to overcome the
time lag between the extension of an insurance commitment and the
payment of claims that currently distorts the government’s cost for these
programs on an annual cash flow basis. To the extent practicable, the
government’s ultimate cost is the key information for budget
decision-making.

The Federal Accounting Standards Advisory Board (FASAB) has done
significant work to develop financial reporting standards to meet the
needs of the various users of federal financial statements.3 The accounting
principles developed by FASAB provide a sound foundation for federal
financial statements that are useful and relevant to needs of the federal
environment. FASAB’s work also provides a useful framework for
understanding the use of accrual cost measures for budgeting for federal
insurance programs. As such, efforts to apply accrual-based budgeting for
federal insurance should build on and further adapt this work for budget
purposes.




3
For a detailed discussion of uses, user needs, and objectives of federal financial reporting, see
Objectives of Federal Financial Reporting: Statement of Recommended Accounting and Reporting
Concepts, Federal Accounting Standards Advisory Board, July 1993.



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                        The focus and purpose of federal budget reporting argues for the use of
The Risk-Assumed        forward-looking cost measures for federal insurance programs if
Concept Is Most         reasonably reliable ones can be developed. In order to support current and
Appropriate for         future resource allocation decisions and formulate fiscal policy, the
                        federal budget needs to be a prospective document that enables and
Budgeting for Federal   encourages users to weigh the future consequences of current decisions.
Insurance Programs      To do this, the budget should provide the information and incentives
                        necessary to assess the future implications of various choices. For federal
                        insurance programs, the information needed for budgeting is roughly
                        analogous to the insurance rate-setting process because the relevant
                        question in assessing the government’s ultimate cost is whether premiums
                        over the long term will be sufficient to cover losses and, if not, what
                        subsidy the government is agreeing to provide. That is, when the federal
                        government decides to undertake the role of the insurer, policymakers
                        need information on the cost of the risk inherent in the government’s
                        commitment.

                        The risk-assumed cost measure4 would provide the prospective
                        information necessary for budget decisions about insurance programs. For
                        insurance programs, risk assumed generally refers to the portion of the full
                        risk premium based on the expected cost of losses inherent in the
                        government’s commitment that is not charged to the insured.5 As a result,
                        the government’s subsidy cost—the difference between the full-risk
                        premium and actual premiums charged—may be more visible in the
                        budget process. Thus, the use of risk-assumed estimates in the budget
                        would provide the information necessary for assessing the cost of
                        establishing reserves and the ability of an insurance program to pay future
                        losses. This approach is similar to that used under credit reform to
                        measure the cost of direct loans and loan guarantees. However, because of
                        the wide variety of risks covered by federal insurance programs, the
                        risk-assumed concept may be interpreted differently depending on the
                        nature of the program. For example, the time horizon used to estimate the
                        risk assumed by the government under deposit insurance may be shorter
                        than that used to estimate the risk assumed in providing life insurance
                        coverage to federal employees.

                        4
                         As noted earlier, there are two general ways that measure the cost of future claim payments for
                        budgeting purposes: a measure based on the risk inherent in the insurance and a measure based on the
                        occurrence of an insured event. The latter measure is used to record claims liability in financial
                        statements for most federal insurance programs.
                        5
                         As will be discussed in chapter 5, the concept of risk assumed—losses inherent in the government
                        commitment—is consistent for all federal insurance programs, but how risk assumed is calculated,
                        such as the time period considered, may vary across insurance programs. In some cases, estimating
                        the full-risk premium might prove to be prohibitively difficult and modifications to the risk-assumed
                        concept may be necessary.



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The risk-assumed concept expands upon the standards used for financial
statement reporting. Except in the case of life insurance, the risk-assumed
concept takes a longer look forward than standards used to recognize
insurance liabilities in financial statements. Under standards developed by
FASAB, the financial statements for all federal insurance programs must
recognize a financial statement liability based on insured events that have
been identified by the end of the accounting period.6 The standard requires
recognition of the expected unpaid net claims inherent in insured events
that have already occurred, including (1) reported claims, (2) claims
incurred but not yet reported,7 and (3) any changes in contingent liabilities
that meet the criteria for recognition.8 Life insurance programs are
required to recognize a liability for future policy benefits9 in addition to the
liability for unpaid claims. This means that except for life insurance, no
liability for an insurance cost is recognized in the financial statements
until it is probable that a cost has actually been incurred and the amount
of the cost can be reasonably estimated. These liability reporting
requirements closely parallel the liability reporting requirements for
private sector insurance companies10 and are based on the principles that
are essential to support the purposes of financial statement reporting.11



6
Statement of Federal Financial Accounting Standards No. 5, Accounting for Liabilities of the Federal
Government.
7
 Claims relating to insured events that have occurred but have not yet been reported to the insurer as
of the date of the financial statements.
8
 Under FASAB standards, contingent losses are only reported as a liability and charged to expenses if
a past transaction or event has occurred and the loss is both probable (events are likely to occur) and
measurable.
9
 The liability for future policy benefits represents the expected present value of future outflows paid
to, or on behalf of, existing policyholders, less the expected present value of future net premiums to be
collected from those policyholders.
10
  Standards for private sector entities are promulgated by the Financial Accounting Standards Board
(FASB). Applicable standards include Statement of Finanical Accounting Standards (SFAS) No. 5:
Accounting for Contingencies, SFAS No. 60: Accounting and Reporting by Insurance Enterprises, and
SFAS No. 97: Accounting and Reporting by Insurance Enterprises for Certain Long-Duration Contracts
and for Realized Gains and Losses From the Sale of Investments. FASB considered and rejected
catastrophic reserve accounting for property and casualty insurance. A key consideration in this
decision was the ability of private sector insurance companies to recoup losses in premiums charged
to policyholders. FASB viewed the long-run nature of pricing premiums as separate from and not a
determinant of when a liability should be recorded. This reflects the different requirements and needs
of traditional accrual liability recognition and the needs of federal budgeting. As noted earlier,
accrual-based budgeting for insurance programs is more closely related to the premium rate-setting
(internal management) process of private sector companies than to their external (liability) reporting
process.
11
 Examples of these principles include reliability, relevance, consistency, comparability, and
materiality.



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In developing these standards, FASAB also recognized the importance of the
risk-assumed measure for federal insurance programs. Because the
risk-assumed measure provides important information beyond that
included in the financial statement liability, FASAB recommended and the
final standards require that this information be disclosed as supplemental
information beginning with financial statements for fiscal year 1997.12
However, concerns about the measurability and the exact nature of some
risks assumed by the government dissuaded FASAB from recommending the
use of risk-assumed estimates as the basis for liability recognition in the
financial statements. Disclosure of risk-assumed estimates provides users
with a broader and prospective cost measure that FASAB believes is
relevant in assessing whether future budget resources will be sufficient to
sustain public services and meet obligations.

The accrual-based cost measures appropriate for the budget differ from
those appropriate for financial statements largely because of differences in
the primary purposes of the information, the nature of the federal budget
environment, and differences in the acceptable level of uncertainty for
financial statements and budget projections. In the past, CBO13 and OMB14
have expressed concerns about the limitations of traditional financial
reporting standards for assessing future budgetary costs of insurance
programs. Generally speaking, traditional financial statement reporting is
of limited use for budget purposes because, in most cases, it does not
recognize the potential costs of claims that have not yet been incurred15 or
the present value of future premiums16 that offsets future budgetary costs.
Federal accounting standards requiring supplemental disclosure of an
estimate of the risk assumed should improve the recognition of these
potential costs in federal financial statements.



12
 Risk-assumed estimates for all insurance and guarantee programs will be reported as required
supplementary stewardship information. For insurance programs administered by government
corporations, which follow FASB (private sector) accounting standards, risk-assumed estimates will
be reported only when financial information on the government corporation is consolidated into
general purpose financial reports of a larger federal reporting entity.
13
 Budgetary Treatment of Deposit Insurance: A Framework for Reform, Congressional Budget Office,
May 1991.
14
  Budgeting for Federal Deposit Insurance, Office of Management and Budget, June 1991.
15
  In 1991, the Federal Deposit Insurance Corporation adopted a somewhat more prospective view of
what constitutes an accountable event for the purpose of recognizing estimated future deposit
insurance losses. It now includes an estimated loss from institutions that are solvent at year-end, but
which have adverse financial trends and will probably become insolvent in the future.
16
 Under traditional financial accounting standards, revenue generally cannot be recognized until it is
earned.



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The benefits achieved by budgeting using financial statement liability
recognition standards would vary across the insurance programs. The
benefits achieved depend primarily on the length of time between the
occurrence of insured events and payment of claims. For some programs,
the traditional liability recognition standards may yield information not
very different from what is currently reported on a cash basis in the
budget. However, for programs with long time lags between the
occurrence of the insured event and the payment of claims, such as
pension and deposit insurance,17 budgeting based on financial statement
liability standards might provide earlier budget recognition of the costs
incurred than does cash-based budgeting. In these cases, the earlier
recognition could reduce the incentive to delay the payment of claims and
would allow for some earlier action to reduce future costs. In most cases,
however, this approach would not be as forward-looking as the
risk-assumed concept and, therefore, would not provide recognition of the
risks inherent in the government’s commitment at the time that the
insurance is extended. It is at that time that decisions can be made to
change the extent of the risk being assumed by the government. Since the
financial statement liability standards generally report costs that have
been incurred as the result of past decisions, using that standard for
estimating the government’s cost in the upcoming budget year may not
provide signals of the government’s risk exposure early enough so as to
maximize options available for limiting program costs. This is true because
the range of options for changing the program to reduce the government’s
costs may be more limited after the cost has been incurred than it would
have been when the insurance was extended. Nevertheless, until
risk-assumed estimates are fully developed, insurance programs’ financial
statements, which are included in the budget appendix, provide
policymakers with valuable information on insured events (losses) that are
probable and measurable as of a given date and should be considered in
budget discussions.

Table 4.1 compares the potential benefits of accrual-based budgeting using
these two cost recognition standards. The potential benefits of
accrual-based budgeting based on the risk-assumed concept included in
table 4.1 are discussed in the following section.




17
  This is based on the experience in the late 1980s in which financial institutions were allowed to
remain open for months or years after becoming insolvent. Future experience may be different. The
Federal Deposit Insurance Corporation Improvement Act of 1991 requires the prompt closure of
severely under-capitalized financial institutions.



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Table 4.1: Usefulness of Cost
Recognition Approach for Improving                                                           Life insurancea
Budget Treatment                                                                 Financial
                                                                                 statement liability
                                     Benefit of change in budget treatment       recognition         Risk assumed
                                     Recognizes the risk assumed by the          X                  X
                                     government at the time the commitment
                                     is made
                                     Improves the information and incentives     X                  X
                                     for managing insurance costs
                                     Provides comparable cost information at     X                  X
                                     the time decisions are made
                                     Establishes “reserve” for                   X                  X
                                     sporadic/catastrophic events
                                     Reflects the timing and magnitude of the    X                  X
                                     program’s economic impact




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                  PBGC                                  Deposit insurance                                     Other insurance
Financial                                Financial                                             Financial
statement liability                      statement liability                                   statement liability
recognition           Risk assumed       recognition                 Risk assumed              recognition               Risk assumed
                      X                                              X                                                   X


b                                        b                                                     b
                      X                                              X                                                   X

                      X                                              X                                                   X

                      X                                              X                                                   X

                      X                                              X                                                   X

                                             Note: Assumes that reasonably reliable risk-assumed cost measures can be developed.
                                             a
                                              The financial statement liability for life insurance is measured on a risk-assumed basis.
                                             b
                                              Method may improve information provided in the budget but not to the extent of risk-assumed
                                             information.




                                             Accrual-based budgeting for federal insurance programs based on the
Accrual-Based                                risk-assumed concept18 has the potential to improve the information and
Budgeting Has the                            incentives for resource allocation and fiscal policy by overcoming many of
Potential to Improve                         the deficiencies of cash-based budgeting. Specifically, the potential
                                             benefits of accrual-based budgeting for federal insurance programs
Resource Allocation                          include
and Fiscal Policy
                                             providing more accurate and timely recognition of the government’s cost
Decisions                            •
                                             of insurance commitments,
                                     •       improving the information and incentives for managing insurance costs,
                                     •       making cost information for insurance programs more readily comparable
                                             to other federal programs,
                                     •       providing a mechanism to establish reserves for high or catastrophic loss
                                             years, and
                                     •       reflecting more accurately the economic impact of insurance programs.

                                             However, the extent to which a shift to accrual-based budgeting will
                                             change the information and incentives varies across insurance programs.


                                             18
                                               In the remainder of this report, all references to accrual-based budgeting assume the use of the
                                             risk-assumed measurement basis.



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                             This is due primarily to differences in the size and length of the
                             government’s commitment, the nature of the insured risk, and the extent
                             to which costs are currently recognized in budget authority and
                             obligations at the time the budget decisions are made. In addition, the
                             approach used to incorporate risk-assumed estimates into the budget will
                             affect the degree to which each achieves these benefits. Three general
                             approaches to using accrual-based estimates in the budget will be
                             discussed in chapter 6.


Accrual-Based Budgeting      Accrual-based budgeting for federal insurance programs has the potential
Would Provide More           to reduce the cost distortions that occur in the cash-based budget by
Timely Recognition of the    improving the match between estimated revenues and claims of insurance
                             commitments. By doing so, accrual-based budgeting would recognize any
Government’s Cost for        imbalance or net cost to the government—the key information that should
Insurance Commitments        be considered in budget decision-making—in the year the insurance is
                             extended.

                             The prospective recognition of insurance costs is the key advantage of
                             accrual-based budgeting for federal insurance programs. Unlike the
                             current cash-based budget, accrual-based budgeting would recognize and
                             report the government’s costs for insurance commitments at the time
                             decisions are made and costs are controllable. As a result, the adoption of
                             accrual-based budgeting for federal insurance programs would shift the
                             focus of the budget from retrospective reporting to prospective cost
                             estimation.


Accrual-Based Budgeting      The prospective focus of accrual-based budgeting has the potential to
May Improve the              improve both the opportunities and incentives for controlling insurance
Information and Incentives   costs by providing more timely warning of emerging problems. Under
                             accrual budgeting, the subsidy costs—the difference between expected
for Managing Insurance       losses and expected income—would be included in the budget and serve
Costs                        as a gauge of the government’s risk exposure. Thus, policymakers would
                             be encouraged to examine the underlying benefits and structure of
                             insurance programs before large losses accumulate. Since policymakers
                             are prompted to take action to reduce costs when costs are still
                             controllable, the potential for unintended subsidies may be reduced. For
                             example, according to OMB, the subsidy conveyed by deposit insurance
                             rises with increased exposure, such as an increase in the number of weak
                             institutions, and falls as policies are put in place that effectively limit
                             risk-taking with insured funds. Thus, if properly recognized in the budget,



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                            the growing subsidy cost for deposit insurance would have signaled
                            policymakers in the 1980s that thrifts and banks were undertaking greater
                            risks and depending more heavily on deposit insurance guarantees.

                            In cases where the Congress intends to provide a subsidy in order to
                            achieve some public policy objective—as is the case for some veterans life
                            insurance programs and the flood insurance program—accrual-based
                            budgeting would prompt recognition of the subsidy cost at the time the
                            coverage is extended. Thus, the cost recognition in the budget would be
                            more clearly linked to the decision to provide subsidized coverage rather
                            than merely reflecting the unfunded bills when they come due.

                            The earlier reporting of costs on an accrual basis not only changes the
                            information available to policymakers but also changes budget incentives
                            if actually incorporated into outlays and/or budget authority. Unlike
                            cash-based budgeting that delays cost recognition and does not encourage
                            early action to control cost, the earlier cost recognition provided by an
                            accrual basis shifts the budget incentives in favor of reforms aimed at
                            controlling costs. For example, under some accrual-based budgeting
                            approaches, policymakers would be faced with a choice of providing
                            additional government funding to cover shortfalls, raising premiums, or
                            otherwise reducing program benefits to reduce future costs. However, the
                            extent to which budget incentives are changed depends on the nature of
                            the particular insurance program, the accrual-based budgeting approach
                            used, and the extent to which budget recognition leads to choices between
                            additional funding and programmatic changes. These issues are discussed
                            in more detail in chapters 6 and 7.


Accrual-Based Budgeting     The use of accrual-based budgeting for federal insurance programs also
May Improve Relative Cost   has the potential to improve the information available to make relative
Information                 cost comparisons. As discussed in chapter 3, the cash-based budget may
                            misstate the government’s cost for insurance commitments. On a cash
                            basis, some insurance programs may appear profitable while subjecting
                            the government to long-term costs. As a result, cost comparisons with
                            programs whose costs are fully reflected on a cash basis will be distorted.
                            Accrual-based budgeting allows for better relative cost comparisons by
                            recognizing the government’s expected costs for insurance commitments
                            at the time decisions are made. For example, for fiscal year 1993, an
                            accrual-based budget would have shown that PBGC had a potential future
                            cost to the government rather than being an income generator as reflected
                            in the cash-based budget. As a result, pension insurance would have



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                          competed for budget resources with other federal programs based on the
                          government’s expected cost rather than appearing to be a source of
                          income in budget terms.


Accrual-Based Budgeting   In addition to improving cost recognition and resource allocation,
for Insurance Programs    accrual-based budgeting for insurance programs would provide
Would Provide a           policymakers with a mechanism for establishing program reserves for
                          expected insurance losses. One outcome of budgeting based upon the full
Mechanism for             risk assumed by the government would be that in some years premiums
Establishing Program      collected and subsidies provided by the government would exceed cash
Reserves                  payments for insured losses. This would occur because losses for some
                          programs are highly variable from year to year and for other programs may
                          not occur for many years. As a result, when premiums and the government
                          subsidy exceed claim payments, funds could be held in reserve for
                          expected future claims.

                          The establishment of reserves may be particularly important given that
                          many of the risks insured by the federal government are catastrophic in
                          size and/or erratic in occurrence. The uneven occurrence of these risks
                          makes estimating funding needs on an annual basis difficult because
                          actual losses in any particular year may vary, in some cases significantly,
                          from the estimated annual cost based on the long-term expected risk. For
                          example, a widespread drought can result in claim payments in a single
                          year to a large proportion of farmers insured under the crop insurance
                          program. Charging premiums sufficient to cover a catastrophic loss in any
                          one year would be prohibitively expensive. As a result, in order for the
                          program to be financially sound, amounts sufficient to cover high or
                          catastrophic losses need to be accumulated over a number of years. Other
                          federal insurance programs, such as life and pension insurance, commit
                          the government to making payments many years in the future. As a result,
                          premiums collected over the duration of the policy must be held in reserve
                          to pay the promised benefits at some future date. If, over time, sufficient
                          reserves are accumulated to pay expected costs, the program would be
                          fully funded.19 However, a program could require additional funds—or
                          borrowing authority—if significant losses occur before sufficient reserves
                          are accumulated even if annual funding is based on the long-term expected
                          cost.



                          19
                           The government’s cost would be funded from the perspective of the program but not of the
                          government as a whole since under current practice reserves are held in Treasury securities (i.e.,
                          borrowed by the Treasury to finance other government spending).



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                            Accrual-Based Budgeting Has the Potential
                            to Improve Budget Information and
                            Incentives for Most Federal Insurance
                            Programs




                            While accrual-based budgeting for insurance programs would recognize
                            any government subsidy at the time insurance is extended and hold such
                            amounts in reserve,20 the government’s financing needs would not change.
                            As is the current practice with insurance and many other funds, when a
                            program’s collections exceed its cash needs for payments, reserves are
                            held in Treasury securities (i.e., lent to the government), which, from a
                            governmentwide perspective, satisfies some of the government’s
                            borrowing needs. Under accrual-based budgeting, federal borrowing (or a
                            reduction in other spending) would still be necessary when the insurance
                            fund redeemed its Treasury securities to make cash payments if insurance
                            claims exceeded premiums collected from the public in a given year.
                            However, under accrual-based budgeting, the government’s cost for the
                            program would have already been recognized in the budget when the
                            commitment was extended.


Accrual-Based Budgeting     In addition to improving the information and incentives for resource
May Improve the             allocation, accrual-based budgeting would better reflect the fiscal impact
Information on the Fiscal   of federal insurance programs. Although accrual-based reporting would
                            lessen the extent to which the budget reflects the government’s borrowing
Impact of Insurance         needs, it would generally reflect the effects of an insurance program on
Programs                    the economy closer to the time when they occur by incorporating a
                            prospective estimate of the program’s accruing cost. Discerning the
                            economic impact of insurance programs can be difficult, but private
                            economic behavior generally is affected when the government commits to
                            providing insurance coverage and thus lowers the risk to the insureds.
                            Therefore, accrual-based budgeting, which, by recognizing the
                            government’s costs at the time the insurance is extended, would better
                            reflect the timing and magnitude of the economic impact of these
                            programs than the current cash-based reporting of outlays in the budget.
                            Further, approaches to accrual-based budgeting that recognize accrued
                            cost in net outlays would remove the uneven cash flow patterns of
                            insurance programs from the budget deficit. By removing temporary
                            working capital needs of deposit insurance programs and large sporadic
                            payments for disaster insurance claims, accrued cost measures would
                            provide a truer measure of the government’s underlying fiscal condition.




                            20
                             The degree to which the government’s cost is recognized in budget authority, outlays, and the deficit
                            depends on the approach used to incorporate accrual-based measures in the budget. The advantages
                            and disadvantages of different approaches are discussed in chapter 6.



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                     Accrual-Based Budgeting Has the Potential
                     to Improve Budget Information and
                     Incentives for Most Federal Insurance
                     Programs




                     Although the use of accrual-based budgeting for federal insurance
Benefits of          programs has the potential to overcome a number of the shortcomings of
Accrual-Based        cash-based budgeting for these programs, a number of factors influence
Budgeting for        the extent to which the information and incentives for a particular
                     insurance program would be changed. These factors include individual
Individual Federal   program characteristics, a program’s BEA spending classification, the
Insurance Programs   extent to which costs are already recognized in cash-based estimates, and
                     the approach used to incorporate accrual measures in the budget. Further,
Will Depend on       the effective implementation of an accrual-based budgeting approach
Several Factors      depends on the ability to generate reliable risk-assumed estimates.

                     The characteristics of individual insurance programs will influence the
                     potential benefits achieved under accrual-based budgeting. As noted in
                     chapter 3, the larger the government’s commitment relative to total federal
                     spending, the greater the potential for budget and fiscal policy distortions
                     and the greater the need to capture the government’s cost at the time the
                     commitment is made. Thus, the larger size of the deposit and pension
                     insurance programs make the benefits of accrual-based budgeting more
                     pronounced than for other smaller programs.

                     In general, the effects of shifting to an accrual-based approach would be
                     beneficial for long-duration insurance programs with large subsidies. In
                     these cases, the shift to accrual-based budgeting may affect the magnitude
                     of the reported program cost in the budget, or whether the program is
                     reported as having a cost rather than cash income. However, it does not
                     appear that the benefits of accrual-based budgeting would be as great for
                     programs that offer short-duration insurance coverage and experience
                     relatively frequent claims, such as crop or flood insurance. For these
                     programs, the benefits of accrual-based budgeting primarily would be in
                     recognizing the cost of less frequent catastrophic losses and eliminating
                     the effect of programs’ uneven cash flows on the budget deficit.

                     As discussed later in the report, whether the program is classified as
                     mandatory or discretionary under BEA will also influence the degree to
                     which increased cost recognition is likely to influence budget incentives.21
                     For mandatory programs, accrual-based budgeting’s effect on decisions
                     would be most apparent when legislated program changes—such as an
                     increase in benefits—are considered. For discretionary programs,
                     accrual-based budgeting may have a more significant influence on budget


                     21
                       Under BEA, budgetary resources are classified as either discretionary or mandatory. Discretionary
                     refers to program spending that is controllable through annual appropriation acts. Mandatory refers to
                     program spending that is relatively uncontrollable without changing existing substantive law.



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Incentives for Most Federal Insurance
Programs




incentives, as their full cost becomes apparent and must be provided for
each year.

The extent to which costs are currently recognized in budget authority and
obligations also influences the degree to which budget information will
change due to a shift to accrual-based budgeting. For example, according
to OMB, the crop insurance program currently estimates annual funding
needs based on the normal loss year at the time decisions are made. In
addition, OPIC currently receives budget authority for and obligates loss
provisions in the year the provisions are recognized. In both cases,
program officials and analysts believe that the current budget treatment
adequately reflects the program’s expected costs at the time budget
decisions are made.

If accrual-based budgeting were to be undertaken, the approach used to
incorporate accruals into the budget will also have an impact on the extent
to which budget information and incentives are changed by a shift from
cash-based budgeting to accrual-based budgeting. As will be discussed in
chapter 6, different approaches to accrual-based budgeting incorporate
these costs into the primary budget data—budget authority, net outlays,
and the deficit—to varying degrees. Finally, the feasibility of accrual-based
budgeting will depend on whether reasonable unbiased estimates of the
risk assumed by the government for the various programs are available or
can be developed. Estimation challenges and other implementation issues
that will have to be addressed in order to achieve the potential benefits of
accrual-based budgeting will be discussed in the chapters that follow.




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Estimation Limitations at Center of Accrual
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                      A crucial component in the effective implementation of accrual-based
                      budgeting for federal insurance programs is the ability to generate
                      reasonable, unbiased estimates of the risk assumed by the federal
                      government. Although in most cases the risk-assumed concept is relatively
                      straightforward, generating estimates of these costs is considerably more
                      complex. The development and acceptance of methodologies to estimate
                      the risk assumed by the government varies significantly across the federal
                      insurance programs we reviewed. The following sections discuss some
                      limitations of existing risk assessment approaches that might be used to
                      generate risk-assumed cost estimates under an accrual-based budgeting
                      approach.


                      The risk assumed by the government is most easily thought of as the
Calculation of Risk   difference between the actual premiums paid by the insured and the
Assumed by the        premiums necessary to fully cover losses inherent in the coverage
Government Is         provided. This difference between the full risk premium and the actual
                      premium charged—the “missing premium”— represents the government’s
Complex               subsidy cost for the insurance program. In general, decision-making is best
                      informed if this subsidy cost is known at the time a commitment is made.
                      This would suggest that to the extent practicable, the budget ought to
                      reflect this subsidy cost. Under an accrual-based budgeting approach, it
                      would be recognized1 at the time the government extends insurance
                      coverage. The ability to assess the risk covered by the various insurance
                      programs is central to being able to determine the subsidy cost to the
                      government. This task is made difficult by the nature of the risks insured
                      by the government and the methodological and data limitations discussed
                      below.

                      For insurance, the accuracy of estimated future claims is determined by
                      the extent to which the probability of all potential outcomes can be
                      determined. Unfortunately, these probabilities are not known with
                      certainty for most activities more complex than the toss of a fair coin.
                      However, for activities in which data on actual outcomes exist, the
                      underlying probabilities can be estimated based on the law of large
                      numbers.2 When these conditions are understood and the probabilities of
                      future events can be inferred, estimates are said to be made under the

                      1
                       The question of whether the subsidy is included as supplemental information, budget authority only,
                      or in both budget authority and outlays is discussed in the next chapter.
                      2
                       The law of large numbers holds that as the number of independent observations increases, the
                      proportion of times a certain outcome occurs tends to approach the underlying probability assuming
                      that the same conditions exist. If statistical evidence is available, changes in underlying conditions can
                      be taken into account.



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condition of risk. In other words, since the possibility of each outcome can
be estimated, the risk undertaken by the insurer can be measured.
However, when underlying conditions are not fully understood estimates
are made under uncertainty. For most federal insurance programs, this
latter case holds due to the nature of the risks insured, program
modifications, and other changes in conditions that affect potential losses.
Thus, estimating the government’s subsidy cost, including the time period
considered, may vary by program out of necessity.

Complete data on the occurrence of insured events over a sufficiently long
period and under similar conditions are generally not available for many
federal insurance programs. Frequent program modifications as well as
fundamental changes in the activities insured reduce the predictive value
of historical data and further complicate risk estimation. For example, the
crop insurance program has been modified a number of times by the
Congress in the last 15 years affecting key conditions, such as
participation rates. Similarly, advances in technology and new competitive
pressures have significantly transformed the banking and thrift industries.

These factors, which limit the ability to predict losses and the potential for
catastrophic losses, have been cited as preventing the development of
commercial insurance markets for the risks covered by federal insurance
programs. As a result, private sector comparisons are generally
unavailable to aid in the risk estimation process for these programs. For
example, although several private sector companies offer aviation war-risk
insurance, the coverage is generally limited to random acts of terrorism
and often excludes areas of military conflict. Federal war-risk insurance is
only made available when commercial insurance cannot be obtained or is
available only on unreasonable terms and conditions and it is in the
national interest to provide air service to a particularly risky area. The risk
inherent in these two situations is not comparable.

Some have suggested the use of simple historical loss averages as an
alternative to the complex estimation methodologies. However, the same
conditions discussed above that make risk estimation difficult may reduce
the usefulness of this alternative. Losses incurred under most of the
federal insurance programs over a 10- or 20-year period may not
adequately capture the risk inherent in the insurance because such
relatively short experience periods do not encompass the full range of
possible outcomes, including infrequent catastrophic events. Historical
averages also may not be reflective of future losses if there have been




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                              program changes or changes in underlying conditions that may affect
                              outcomes.


                              The extent to which risk assessment methodologies are currently
Ability to Estimate the       developed and accepted varies significantly across federal insurance
Risk Assumed by the           programs. Some federal insurance programs, such as the life insurance
Government Varies             programs, cover risks that are commonly insured by the private sector and
                              are based on widely accepted actuarial science. However, as discussed in
Across Programs               earlier chapters, most federal insurance programs cover catastrophic or
                              case-specific risks that the private sector has been unwilling or unable to
                              cover. Risk assessment for these programs is considerably more
                              challenging. For some insurance programs, such as deposit insurance,
                              several quantitative risk assessment techniques have been developed but
                              there is no strong consensus supporting any particular technique. For
                              other federal insurance programs, such as the war-risk insurance
                              programs and OPIC’s political risk insurance, risk assessment currently
                              relies heavily on expert judgment rather than highly quantitative or
                              standardized risk assessment methods.

                              Given these estimation challenges and the shortcomings of cash-based
                              budgeting, consideration of the adequacy of risk-assumed estimates for
                              budget purposes is likely to be most beneficial when the focus of the
                              discussion is on whether these estimates would provide policymakers with
                              more timely information and signals about the underlying insurance
                              programs. For these purposes, what is important is that the estimates are
                              based on the best information available at the time the insurance
                              commitment is extended. In this sense, it may be most important that the
                              budget information and incentives provided to policymakers be “more
                              approximately right rather than precisely wrong.”3

                              The remainder of this chapter discusses risk assessment for the various
                              types of federal insurance programs we reviewed:

                          •   life insurance;
                          •   disaster insurance (flood and crop insurance);
                          •   deposit insurance;
                          •   pension insurance; and
                          •   other insurance (war-risk, political risk, and vaccine injury insurance).

                              3
                               The Congressional Budget Office used this phrase to characterize the difference between
                              accrual-based cost estimates and cash-based reporting in advocating accrual-based budgeting for
                              credit programs. See Credit Reform: Comparable Budget Costs for Cash and Credit, Congressional
                              Budget Office, December 1989.



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                         The sections that follow are ordered approximately according to the
                         current level of the development and acceptance of methodologies that
                         could be used to estimate the risk assumed by the government. The first
                         programs discussed—life insurance—have a methodology that is well
                         established in actuarial science. Next, we discuss disaster insurance
                         programs for which methodologies have been developed and used to set
                         risk-related premiums. These methodologies may provide a useful
                         foundation for estimating the risk-assumed costs for these programs. For
                         the large programs—deposit and pension insurance—competing
                         methodologies exist or are under development that potentially could be
                         used to estimate risk-assumed costs; however, little consensus exists on
                         any one model. The remaining programs—overseas private investment,
                         vaccine injury, and war-risk insurance—present significant estimation
                         challenges and rely heavily on expert judgment.



                         The methodology for measuring the risk assumed by the government
Risk Assessment for      under life insurance programs for government employees and
Life Insurance Has Its   service-disabled veterans is well established in actuarial science. The
Foundation in            certainty of death and the compilation of extensive data on mortality have
                         made it possible to estimate future life insurance claims with a high level
Actuarial Science        of accuracy. The Department of Veterans Affairs (VA) and the Office of
                         Personnel Management (OPM) currently use actuarial approaches that are
                         the standard practice of the life insurance industry. Although
                         modifications are made to reflect the unique characteristics of the insured
                         groups, the basic assumptions used are comparable to those used by
                         commercial life insurance companies.

                         By applying the laws of probability to mortality statistics, actuarial science
                         provides a methodology to estimate future rates of death. A basic principle
                         of actuarial science states that by studying the rate of death within any
                         large group of people and gathering information on all factors that may
                         affect that rate, it is valid to anticipate that any future group of persons
                         with approximately the same factors will experience the same rate of
                         death. Mortality tables are constructed to reflect probabilities of death at
                         each age. The accuracy with which the estimated future claims
                         approximate actual experience depends upon two key factors: (1) the
                         accuracy and appropriateness of the underlying mortality statistics and
                         (2) the number of observations the estimate is based on and the number of
                         individuals insured.




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                             Most mortality tables in use today are based upon the experience of
                             commercially insured individuals. Because the mortality experience of
                             federal employees appears to be different from the experience used to
                             construct these tables, OPM constructs its own mortality tables based on
                             program experience to more accurately capture the insurance risk. VA also
                             conducts periodic studies of mortality and disability to ensure that its
                             assumptions are sufficiently conservative. The information on mortality,
                             together with data on policy benefits and interest rate assumptions, makes
                             it possible to calculate the present value of future insurance claims. The
                             extent to which this amount differs from premium and investment income
                             would constitute the risk assumed by the government or the government
                             subsidy. However, as is the case with most long-term forecasts, estimates
                             of a life insurance program’s income are sensitive to interest rates. For
                             example, interest earnings on funds collected from policyholders are a
                             significant source of revenue in the Federal Employees’ Group Life
                             Insurance program. OPM officials cited the difficulty in forecasting
                             fluctuations in interest rates over the long term as a weak point in the
                             estimation process.


                             The two disaster insurance programs we reviewed—the National Flood
Disaster Insurance           Insurance program and the Federal Crop Insurance program—currently
Programs Have                have established methodologies for setting risk-related premium rates.
Established                  These methodologies and the corresponding agency risk assessment
                             experience should provide a useful foundation for estimating the cost of
Rate-Setting                 the risk assumed by these programs if an accrual-based budgeting
Methodologies                approach is adopted. However, some modifications and refinements to the
                             methodologies and other implementation challenges should be expected.
                             Further, as is the case with all modeling efforts, professional judgment and
                             underlying assumptions are necessary components of these
                             methodologies.


Flood Insurance Losses       The Federal Insurance Administration (FIA) has an established rate-setting
Are Erratic but Measurable   model, which, according to FIA, could be used to assess the risk assumed
Over the Long Term With a    for policies issued by the National Flood Insurance Program (NFIP).4 FIA
                             officials told us that this model is based on generally accepted actuarial
Fair Degree of Accuracy      principles and has been used by the agency for years to set premium rates


                             4
                              For additional information on the Flood Insurance Program and its rate-setting methods, see Flood
                             Insurance: Financial Resources May Not Be Sufficient to Meet Future Expected Losses
                             (GAO/RCED-94-80, March 21, 1994) and Flood Insurance: Information on Various Aspects of the
                             National Flood Insurance Program (GAO/T-RCED-93-70, September 14, 1993).



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for unsubsidized insurance policies.5 They told us that the model and its
output, however, do not undergo regular external reviews. In addition to
the rate-setting methodology, the FIA has worked on developing
catastrophic loss estimates that may prove useful in assessing the
appropriateness of reserve levels under an accrual-based budgeting
approach. As an alternative to the detailed rate-setting model, some budget
experts suggested that historical averages—which do not include
catastrophic losses unless they have occurred during the chosen
experience period—may provide a sufficient basis for measuring the
program’s accrual-based costs.

Flood hazards have several characteristics that are important in
considering risk assessment and budgeting for the NFIP. Although the
timing and magnitude of floods is considered unpredictable by more than
a few days or hours, the probability that they will occur is measurable with
a fair degree of accuracy. Flood losses are very predictable in that they
occur in well-defined areas and are inevitable in these areas over the long
run. However, as noted in chapter 3, the erratic nature of floods can have
serious implications for risk assessment and budgeting. A Department of
Housing and Urban Development (HUD) study points out that while most
property and casualty insurance is based on realized losses over a period
of time, this approach is not applicable to flood insurance because of the
highly skewed nature of flooding losses.6 Rather than following the normal
bell-shaped statistical curve, there are many small to moderate floods,
some larger floods, and a few extremely large ones. As a result, an average
of even a considerable number of years may differ significantly from the
true long-term average.

The NFIP illustrates this point. The NFIP is not actuarially sound even
though it has achieved a goal of collecting premium income sufficient to at
least cover expenses and expected losses for an average historical loss
year. This is because the historical experience period, beginning in 1978,
does not include any loss years that can be considered to be of a



5
 NFIP flood insurance premiums are either based on actuarial principles or are subsidized depending
on when the insured structure was built. Subsidized rates are available for structures built before rate
maps were prepared for the areas in which they are located. Premiums for properties constructed after
the rate maps were prepared must be set in relation to risk. See appendix IV for a more detailed
description of the program.
6
 Insurance and Other Programs for Financial Assistance to Flood Victims: A Report From the
Secretary of the Department of Housing and Urban Development to the President, as required by the
Southeast Hurricane Disaster Relief Act of 1965, Senate Committee on Banking and Currency, 89th
Congress, 2nd Session, September 1966.



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catastrophic level for the program.7 As a result, the average historical loss
year involves fewer claim losses than the expected per annum claim losses
in future years. Thus, the premium income currently collected by the
program may not be sufficient to build reserves for potential catastrophic
losses.

Despite this limitation, some budget experts indicated that they thought it
acceptable to use historical averages as the basis for measuring the
program’s accrual cost in the budget while providing some additional
funding mechanism, such as the program’s borrowing authority, to cover
catastrophic losses. Funding this amount would allow for the
accumulation of reserves during years where losses are less than the
historical average.8 According to the FIA, this level of funding in
conjunction with the program’s borrowing authority of $1 billion should be
sufficient to cover costs approximately 85 percent to 90 percent of the
time. Further, the average historical loss year is not a static measure and
could be expected to move toward the long-term average as the
experience period increases over time. Nevertheless, if the objective of
adopting accrual-based budgeting is to recognize the currently
unrecognized government subsidy and/or to accumulate reserves to cover
future losses, including catastrophic losses, then the program’s long-term
expected cost is the most appropriate measure to use as the basis for
measuring the government’s cost in the budget.

FIA officials told us that they were reasonably confident that the actuarial
rate-setting method currently used to establish premium rates for
unsubsidized polices could be used to generate reasonable estimates of
the expected long-term risk for all policies. The difference between the
program’s expected long-term risk and the actual premium rates would
then provide an estimate of the risk assumed by the government. The FIA
estimated this difference or “missing premium” at approximately
$520 million per year.9



7
 According to FIA, the probable maximum loss resulting in $4.5 billion to $5 billion in claim losses has
a 1 in 1,000 chance of occurring. For comparison purposes, Hurricane Hugo resulted in claims of
$0.4 billion.
8
 FIA officials told us that in any particular year, there is about a 40-percent to 45-percent chance that
flooding losses will be less than the historical average and about a 50-percent to 55-percent chance
that flooding losses will exceed the historical average.
9
 According to FIA, $520 million represents the amount of annual general fund appropriations
necessary to build reserves to cover catastrophic losses. FIA told us that if the shortfall was covered
by an increase in premiums, then the annual amount needed would be larger due to corresponding
increases in commission payments and other expenses.



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FIA’smethod for establishing rates for unsubsidized policies follows a
hydrological method based on studies performed by the U.S. Army Corps
of Engineers and private engineering companies. These rates are based on
available hydrological data, flood insurance claims and simulations, as
well as engineering and actuarial judgment.10 According to FIA officials, the
key components of the method are (1) probability estimates of the
frequency with which floods of different severity will occur and
(2) estimates of associated structural property damage incurred due to
different types of floods. Program expense items, such as administrative
costs, are also accounted for in the actuarial rates. These rates are based
on actual risk exposures and generally vary according to risk-related
features, such as the flood zone, the elevation of the structure, and the
amount of insurance purchased.

As is often the case in modeling, professional judgments and assumptions
are necessary to overcome data limitations. For example, the flood
histories used to develop the original estimates of the probability of floods
of different severity were generally not very long. Consequently,
modifications had to be made to prevent statistical bias. In our
discussions, FIA officials described the measurement of flood frequency as
“good as the state of the art” but noted that not every area has been
studied in depth due to resource constraints. Agency officials said that in
these cases, the frequency estimates are based on various histories and
statistical analysis which ad hoc studies have shown to yield reliable
results. In addition, the original estimates of the structural damage caused
by floods of various depths were based on engineering studies and
available flood claims. According to agency officials, these estimates are
regularly updated with claims data, and credibility analysis11 is used to
check validity. Appendix IV provides a more detailed description of the
model and its key data elements.

According to FIA, additional assumptions and judgments would be
necessary if the model were to be used for the entire program because
there is currently a lack of information on pre-flood insurance rate map
(FIRM) properties.12 FIA said that a current study on the impact of charging
actuarial rates for pre-FIRM properties will be gathering additional

10
 We have not independently reviewed the studies on which FIA’s data for actuarial rate-setting are
based.
11
  Credibility analysis is a statistical technique used to determine the degree to which the accuracy of
the experience can be relied on.
12
 Pre-FIRM properties are structures that were constructed before the initial mapping studies for the
FIRMs were completed. The rates for these properties are currently subsidized.



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information on these properties. Agency officials also noted that a
trade-off exists between the benefits of more precise estimates and the
cost of making these improvements. While factors such as the frequency of
remapping and rezoning may affect the quality of the model’s estimates,
the costs of these studies should also be considered. For example, agency
officials stated that even if sampling were done to get more precise
estimates of the evaluations for pre-FIRM properties, the cost of this type of
refinement could outweigh the potential benefits of improved estimates.

FIA has also done some work on developing catastrophic loss estimates
that may be useful in assessing the program’s appropriate reserve levels
under an accrual-based budgeting approach.13 According to FIA, the
method used to estimate catastrophic funding levels uses additional
statistical analysis and simulations in conjunction with the hydrologic
method and is more complex than the actuarial rate-setting method alone.
An FIA official estimated that catastrophic reserve levels of $4.5 billion to
$5 billion should be sufficient 99.9 percent of the time. In recent years, FIA
has been unable to establish reserves and has had to borrow funds from
and repay funds to the Treasury to cover excess losses. These estimates of
catastrophic reserve requirements were described as orders of magnitude,
suitable for program planning purposes, rather than precise estimates. The
FIA official explained that the closer the actual reserve funding level gets to
the estimated amount, the more important data limitations and underlying
assumptions become.

In summary, FIA has an established method for setting risk-related
premiums for its unsubsidized policies. According to FIA, this methodology
could be extended to generate risk-assumed estimates for the entire
program. In addition, FIA’s work on catastrophic reserve requirements may
prove useful in assessing the appropriateness of reserve levels under an
accrual-based budgeting approach. However, while this work should
provide a useful foundation for developing risk-assumed estimates, FIA
indicated that some modifications and refinements would be desirable
before these estimates are used for accrual-based budgeting purposes and
fully funding a reserve level target. One FIA official noted that this may
involve considerable effort.




13
  As discussed in chapter 7, reserve levels are an important consideration because, in order to cover
future losses, reserves need to be based on the long-term expected risk of an insurance program rather
than policies issued in a given year.



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Crop Insurance Program     The Federal Crop Insurance Corporation (FCIC) has an established
Has an Established         premium rate-setting methodology and considerable experience assessing
Rate-Setting Methodology   crop risk. According to FCIC, the basic rate-setting methodology used by
                           the agency—the loss cost ratio method14—is commonly used in the
                           insurance industry. Within agriculture, it is used by the rating bureaus that
                           support the crop-hail insurance industry. Although this methodology could
                           be used as the basis for measuring the program’s cost in an accrual-based
                           budget, several implementation issues stemming largely from the diversity
                           of crop risks and timing differences between the budget cycle, the
                           rate-setting process, and the exposure period would have to be overcome.
                           In addition, some limitations in the methodology’s underlying data and
                           assumptions have been identified. According to the FCIC, internal reviews
                           of the model and its key assumptions are ongoing and an external review
                           of the model by an actuarial firm is underway. This external review should
                           provide additional insights to help evaluate the model’s ability to generate
                           risk-assumed estimates for accrual-based budgeting and identify areas for
                           continued improvement. The last comprehensive review of the
                           methodology was completed in 1983 by the same firm.

                           The nature of crop losses makes risk assessment challenging. In prior
                           reports, we have identified inherent problems in the ability to pool and
                           assess the risk of crop losses.15 Crop losses are not normally
                           independent—some perils are likely to strike a large number of insured
                           farmers in the same crop year. Further, it is difficult to align premium
                           rates directly with risk because the risk associated with growing a
                           particular crop varies by county, farm, and farmer. For example, the risk
                           associated with a particular farmer is influenced by a variety of factors,
                           including farm management practices, soil type, and the productivity of
                           individual tracts of land. Monitoring these individual risks may be neither
                           feasible nor cost-effective. In addition, crop risks are volatile. The
                           performance of any specific crop or any area of the country is subject to
                           wide variations depending on the state of nature. In general, the
                           performance of any particular crop in a county is characterized by
                           relatively infrequent catastrophes of moderate to extreme severity and a
                           number of annual spot losses resulting from noncatastrophic events, such
                           as hail.




                           14
                             The loss cost ratio is calculated by dividing total claim payments by the total insurance in force.
                           15
                            See Crop Insurance: Federal Program Faces Insurability and Design Problems (GAO/RCED-93-98,
                           May 24, 1993) and Crop Insurance: Additional Actions Could Further Improve Program’s Financial
                           Condition (GAO/RCED-95-269, September 28, 1995).



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As a result, the program’s rate-setting methodology is complex. To align
crop insurance premium rates with the associated risk, FCIC establishes
rates that vary by crop, location (county), farm, and farmer. Because of all
the combinations involved, literally hundreds of thousands of premium
rates are in place. These rates are adjusted annually using a multistep
process involving considerable computer analysis and professional
judgment. FCIC begins the process each year by looking at crop insurance
experience over the past 20 years (if available) for each county and state.
On the basis of county and state historical experience, FCIC sets basic rates
for each crop in each county at the 65-percent coverage level for average
production. These basic rates are adjusted for specific risk classifications
including each farming type (such as whether the insured acreage is
irrigated or dry land) and for each crop type (such as winter wheat or
spring wheat). Using these basic rates, FCIC makes several adjustments to
establish rates for other coverage levels and for farmers whose production
levels differ from the county’s average. FCIC’s rate-setting methodology is
described in more detail in appendix IV.

FCIC agreed that this methodology could be used to estimate the program’s
expected risk but noted that data for detailed rate-setting are not available
at the time the budget year submission is prepared. Because the risk of
crop damage is closely aligned with specific characteristics of the crop,
county, and individual farming practices, detailed information on the
composition of coverage extended is necessary to provide projections of
the full risk assumed for policies issued in any given year. However,
detailed information on the composition and volume of policies and
updated premium rates are not available at the time the budget year
submissions are made. FCIC said that reasonable projections of insurance
coverage can be made on a national scale at a higher level of aggregation,
such as by crop type, but considerable uncertainty surrounds more
detailed projections of specific policy coverage, such as crop-county
combinations. Since estimates based on the actual composition of policies
provide a more appropriate measure of the risk assumed, adjustments
based on more detailed information may have to be made when the
information becomes available.

According to FCIC’s senior actuary, FCIC currently bases its budget estimate
on current year sales data adjusted for several factors, such as projections
of commodity prices, planted acres, and anticipated changes in premium
rates. He agreed that this more aggregated approach would provide a
sufficient basis for an accrual-based budget year estimate, even though the
data for detailed rate-setting, including crop/county level data, are not



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available when the budget submission is prepared. He said that the more
detailed rate-setting methodology could subsequently be used to
re-estimate the government’s risk for actual policies issued during the year
by “repricing” these polices using the full risk premium rates when
sufficient information becomes available. The difference between the full
risk premium for policies issued and actual premium collections would
constitute the government’s subsidy costs for policies issued in a given
year. He agreed that the full risk premiums, which take into account
specific risk and generally include amounts for catastrophic losses, are
probably the appropriate basis for establishing reserves under an
accrual-based budgeting approach. Even with this, there are decisions to
be made about the confidence placed in these estimates, which—like
other risk assessment models—depends on the acceptance of the
methodology’s underlying assumptions and data limitations.

A key assumption of the FCIC’s rate-setting methodology is that the 20-year
base period is sufficient to assess the program’s future costs. The FCIC’s
senior actuary acknowledged that the appropriate period to use is
debatable and that any finite number of years is inadequate to observe all
possible states of nature or to assess the probability of each state of
nature. He explained that the 20-year rolling average has been used
primarily due to concerns about the availability, quality, and applicability
of data from the early years of the program.

Our previous work found that premium rates depend heavily on the
number of years included in the experience period and the weight
assigned to each year. For example, in 1983 USDA’s consultant suggested
changing from the current methodology of giving equal weight to each of
the 20 years’ experience to giving greater weight to more recent years’
experience. We found that the consultant’s approach had a significant
impact on the premium rates for three crops of the six major crops we
reviewed.16 The USDA consultant is evaluating whether the trend in losses
in recent years requires a change in the methodology.

Another key assumption is that the sample of previous buyers of crop
insurance is adequately representative of future buyers. Recent changes in
the program have resulted in changes in the characteristics of the buyer
population. As such, there is considerable uncertainty surrounding the
future composition of the insurance portfolio. The model is also based on
a number of secondary assumptions. These include the choice of

16
 Crop Insurance: Additional Actions Could Further Improve Program’s Financial Condition
(GAO/RCED-95-269, September 28, 1995).



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parameters used to (1) allocate basic rates to the various components of
risk, such as crop type and planting practice, and (2) adjust the basic rates
for different coverage and production levels.

Our previous work raised concerns about the adjustments made to the
basic rate level to arrive at rates for coverage and production levels that
differ from those of the basic rate. These adjustments are important
because the majority of all crop insurance is purchased at rates for
coverage and production levels that differ from those covered under the
basic rates. However, our previous work found that these adjustments did
not result in rates that are aligned with risk. For example, to set the rates
for the 75-percent and 50-percent coverage levels, FCIC applies
preestablished mathematical factors to the basic rate.17 According to our
analysis of six major crops, the rates for this insurance were too high at
the 75-percent coverage level and too low at the 50-percent coverage level
in relationship to the basic rates. FCIC, using a mathematical model that
sets rates according to preestablished relationships between production
levels, also adjusts the basic rates for production for farmers whose
historical production levels are above or below the county’s average.
However, as with the varying rates for coverage levels, we found that these
adjustments did not result in rates that accurately reflect the risk involved
at each production level.18 In the past, agency officials cited a lack of time
and resources as a barrier to revising the formulas applied to the basic
rates to calculate these other rates. Currently, however, FCIC and its
consultant are reviewing these factors and FCIC anticipates making
adjustments in the future. Further, the FCIC noted that these differences
may be offsetting in the aggregate and thus may not be as important for
budget purposes as for setting individual farmers’ premium rates.

Additional modeling techniques to aid in assessing the risk of crop losses
may become available in the future. For example, FCIC said it is doing some
work with multistage econometric models and OMB suggested that options
pricing19 could potentially be used to estimate the risk assumed by the
government. However, these methods are only in the conceptual or early
stages of development. The FCIC’s senior actuary told us that the


17
 FCIC multiplies the basic rate at the 65-percent level by 154 percent to arrive at the rate for
75-percent coverage and by 72 percent to arrive at the rate for 50-percent coverage.
18
 According to the FCIC’s senior actuary, recent analysis by FCIC’s actuarial consultant show there is
considerable variation in these relationships by crop and area of the county. There also is debate about
appropriate methodology—experience-based, as done by the GAO, or yield-based, as done by the
consultant.
19
  For a discussion of options pricing, see figure 5.1.



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                       alternative models the FCIC is working on may provide useful supplemental
                       information but are not reliable or useful enough for budget purposes. In
                       addition, the use of these methods would require a significant upgrade in
                       staff skills.

                       In summary, the FCIC has an established rate-setting method that could
                       serve as the basis for estimating the risk assumed by the government.
                       However, risk assessment for crop insurance is complicated by the
                       variation of risk associated with different combinations of crops, counties,
                       and farming conditions and practices. Detailed information to estimate the
                       risk assumed based on specific characteristics of the insureds is not
                       known at the time of the budget year submission. Therefore, a higher level
                       of aggregation—perhaps similar to what is used for current budget
                       estimates—could be used for the budget year estimates. Reestimates for
                       the risk assumed based on actual polices issued in a particular year could
                       then be achieved by repricing the polices based on the full risk premium
                       when necessary information becomes available. Many of the
                       methodology’s assumptions and underlying data limitations are currently
                       under review. This review should provide additional insights into the
                       reasonableness of the methodology and its use for accrual-based
                       budgeting.


                       The historic number of thrift and bank failures in the late 1980s and early
Lack of Consensus on   1990s and the costs associated with resolving these institutions motivated
Risk Assessment        the development of methodologies to estimate future failures and their
Methodology for        expected costs to the government’s deposit insurance funds. In a prior
                       report, we reviewed methodologies used by various federal agencies and
Deposit Insurance      private forecasters.20 We found that different estimation approaches
                       produced widely disparate results due in part to heavy reliance on
                       professional judgment in specifying critical assumptions, such as
                       estimates of market value, and the historical period used to project
                       expected future losses. An analysis by staff of the Office of the
                       Comptroller of the Currency (OCC) concluded that different estimation
                       methodologies have strengths and weaknesses but no one approach
                       appears to be superior.21 Appendix II contains a description of six loss
                       estimation methodologies.


                       20
                        Bank Insurance Fund: Review of Loss Estimation Methodologies (GAO/AIMD-94-48, December 9,
                       1993).
                       21
                        A Comparison of Different Approaches to Projecting Bank Resolutions, Draft Working Paper,
                       Thomas J. Lutton, Robert DeYoung, and David Becher, Office of the Comptroller of the Currency,
                       November 1993.



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The health of the bank, thrift, and credit union industries is subject to
many variables that are extremely difficult to predict. These include
variables related to local and national economic conditions, behavior of
regulators and management, and structural changes in the industries.
Thus, attempting to predict the future prospects of financial institutions
and estimate future losses to the insurance funds is an intrinsically
uncertain proposition. In preparing loss estimates, there is no empirical
formula for forecasters to follow that would enable them to know with
certainty what approach or assumptions can most accurately reflect both
present and future conditions and events that can play a significant role in
the solvency of a financial institution. Only by making many assumptions
can the available methodologies generate estimates of the impact of
changes in the economy, industries, or regulatory behavior on the
government’s cost of providing deposit insurance. In addition, small
changes in these key assumptions can produce large changes in cost
estimates.

Determining the value of an institution’s assets is one of the most
challenging steps in estimating the government’s cost of deposit insurance
losses from failed institutions. Economic insolvency of a financial
institution occurs and costs accrue to the insurance funds when the value
of the institution’s liabilities exceeds the market value of its assets. While
the value of an institution’s liabilities—primarily deposits—is generally
known, the value of its assets—primarily loans—is much more uncertain.
Most loss estimation methodologies rely on unaudited financial data that
financial institutions are required to report—in call reports—to regulatory
agencies. Experience has shown that these data do not always provide an
accurate picture of the value of an institution’s assets. For example, in
1991 we reported that asset valuations prepared by FDIC for 39 failed banks
revealed $7.3 billion in additional deterioration in asset values (losses)
compared to the last quarterly call reports filed by the institutions.22 As a
result, most estimation approaches adjust call report data in an attempt to
approximate the market value of an institution’s assets.

Estimating the market value of an institution’s assets allows for earlier
recognition of the government’s deposit insurance losses than does
reliance on historical book value measures reported in call reports.
However, the use of market-value accounting is still controversial. Market
values are not readily available for all categories of bank and thrift assets
and liabilities. Analysts are divided over whether market-value accounting
is precise enough for financial statements or whether it provides better

22
  Failed Banks: Accounting and Auditing Reforms Urgently Needed (GAO/AFMD-91-43, April 22, 1991).



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                        estimates than book-value accounting. In addition, some models, such as
                        OMB’s, include a closure rule as a policy variable defined in terms of the
                        asset-to-liability ratio of an institution. This variable can (1) be set based
                        on observed behavior of regulators in a given period or (2) reflect prompt
                        closure as mandated by the Federal Deposit Insurance Corporation
                        Improvement Act of 1991. Delay in closing an institution after it has
                        become insolvent has been shown to increase resolution costs.

                        Because of the nature of deposit insurance and the significant challenges
                        associated with estimating the program’s full long-term risk described
                        previously, some departure from the pure risk-assumed cost concept may
                        be appropriate in calculating risk-assumed estimates. For example,
                        experts we consulted with held differing views on the degree to which
                        OMB’s model accounts for the full range of possible future outcomes, such
                        as the catastrophic losses associated with the savings and loan crisis.
                        However, the model’s market-value-based accrual cost estimates would
                        have provided policymakers with earlier recognition of deposit insurance
                        costs than cash-based reporting.

                        The following sections discuss some of the limitations of the various types
                        of models that are currently used by different forecasters to project losses
                        to the deposit insurance funds. An assessment of the applicability and
                        accuracy of any model for estimating the government’s cost for deposit
                        insurance can only be made in the context of alternative models so that
                        the benefits and limitations of different approaches can be compared. The
                        first section highlights some of the limitations of OMB’s options pricing
                        model, which the Bush administration proposed using for accrual-based
                        budget reporting. The second section discusses some of the weaknesses of
                        other loss estimation methodologies. A description of each of the
                        methodologies is included in appendix II.


OMB’s Options Pricing   Although any of the methodologies described in appendix II could be
Model                   adapted to estimate the government’s annual costs of deposit insurance,
                        the focus has been on OMB’s options pricing model because it provides a
                        direct computation of accruing deposit insurance costs. Under OMB’s
                        estimation approach, deposit insurance is treated as giving the owners of a
                        bank or thrift institution the option to transfer its liabilities to the
                        government if the value of its assets falls below that of its liabilities. A
                        brief overview of options pricing theory is provided in figure 5.1. OMB’s
                        deposit insurance model has two distinct components. The first part
                        attempts to estimate the financial condition, or market value, of every



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institution with liabilities over $100 million and then simulate their
financial condition for future years. The second part uses options pricing
techniques to calculate the expected costs of deposit insurance.




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Figure 5.1: Options Pricing Theory and Federal Insurance


   An option is a legal contract between two parties where the seller and the buyer of the option enter
   into an agreement to conduct specified transactions contingent on certain conditions. The party that
   buys and owns the option contract is called the holder of the option. The party that sells an option
   contract is called the writer of the option. A call option gives the holder a right, but not an
   obligation, to buy a specified asset at a predetermined price called the exercise or strike price.
   Similarly, a put option gives the holder a right, though not an obligation, to sell the specified asset at
   a specified exercise price. An American option can be exercised at any time during the length of the
   contract, whereas a European option can only be exercised at the end of the specified period.

   Options pricing theory is used in a variety of applications to estimate the outcome or value of
   uncertain future events. In general, these types of models have two defining features: (1) one or more
   stochastic processes1 which describe possible outcomes from one time period (state) to another and
   (2) a formulation of the outcome (or pay-off) in each state, given the prior sequence of states.
   Determining the value or price of an option is complicated because it is dependent on five factors.
   These factors are: (1) the time to expiration of the option, (2) the exercise price of the option, (3) the
   current asset price, (4) the risk-free interest rate of corresponding duration, and (5) the volatility of
   the asset price.

   The price of an option is directly related to the probability that it will be exercised. Various
   mathematical and simulation methods have been developed to estimate the probability that an option
   will be exercised and the corresponding value of the option. In the case of stock options, the price of
   a put option reflects the expected cost to the seller of the probability that the option will be exercised
   by the buyer. Thus, the price of the put option is analogous to insurance premiums for a policy that
   protects the holder of stock against a fall in price below a specified threshold during a specified time
   period. In competitive markets, the price of the put option should reflect the actuarially fair premium
   for the implied insurance.

   The use of an options pricing framework for valuing the government's deposit insurance commitments
   was pioneered by Robert Merton and later extended by Alan Marcus to estimate the government's
   liabilities resulting from pension guarantees.2 Deposit insurance can be thought of as a put option
   purchased by a financial institution from the government in exchange for the payment of insurance
   premiums. The put option gives a bank or thrift the right to sell its deposit insurance liabilities to the
   government when the value of its assets falls below the value of its liabilities. Pension insurance can
   similarly be viewed as a put option giving firms the right to sell their pension liabilities to the
   government. The OMB models use the options pricing framework to estimate the net government
   liability, defined as the difference between the value of the put option (or the actuarially fair
   premiums) and the actual premiums collected, which are established legislatively.

   1
     A stochastic process is one in which only chance factors determine the particular outcome of a single run through the process
   or trial. The possible outcomes are known in advance, but not the exact outcome of any one trial. The process does have
   some regularity which allows a probability to be assigned to possible outcomes.

   2
    See Merton, Robert C., "An Analytical Derivation of the Cost of Deposit Insurance and Loan Guarantees: An Application of
   Modern Options Pricing Theory," Journal of Banking and Finance, June 1977, and Alan Marcus, "Corporate Pension Policy and
   the Value of PBGC Insurance," Issues in Pension Economics, ch. 3, Z. Bodie, J. Shoven, and D. Wise, eds., University of Chicago
   Press, 1987.

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OMB’s  model is conceptually sound and OMB’s efforts have made a
significant contribution in extending the use of options pricing theory to
estimate government insurance costs. However, a number of modifications
to the model should be considered in order to improve its ability to
estimate the government’s deposit insurance cost. These refinements are
geared toward addressing some of the concerns raised by experts about
the model, including (1) the approach used to value financial institutions’
assets, (2) the treatment of interest rate risk, and (3) the sensitivity of
estimates to the specification of model assumptions and parameter values.

A key assumption of options pricing theory is that asset values are
observable, measurable, and vary randomly over time. For assets for
which there are efficient, well-developed markets, such as stocks, bonds,
agricultural commodities, and foreign currencies, this assumption is not
problematic. However, the value of a financial institution’s assets is not
readily observable or measurable. Although stocks of the very largest
banks are traded actively, adequate market value data are not available for
the many smaller and non-publicly-traded institutions. As such, the
unavailability of market value data on bank and thrift assets is a limitation
of OMB’s options-based approach to estimating deposit insurance costs. In
order to calculate the government’s cost for insuring all institutions, OMB
uses call report data to estimate the market value and volatility in the rate
of return of bank and thrift assets.

OMB’s use of estimated asset values and its method for calculating these
estimates have been criticized. Some financial economists we spoke with
questioned the practical application of options theory in the absence of
observable and measurable market data that are generally available in
more common uses of options theory. The use of an estimate of asset
values is problematic because it may introduce measurement errors if the
input data are not unbiased and efficient estimates of market value. The
lack of an explicitly stated and observable exercise price of the option
makes it difficult to determine when the option would be exercised. In the
OMB model, the exercise price—economic insolvency—is expressed as a
ratio of an institution’s estimated assets and liabilities. The valuation of
assets and liabilities is often difficult and depends on the measurement
basis used, thus identifying the timing of when a firm’s liabilities exceed its
assets can be problematic.

Other financial economists argue that the lack of observable and
measurable market value data for many financial institutions makes the
use of call report data to infer market values a reasonable approach. OMB



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bases its estimate of market value on an institution’s current cash flow23
from call report data and a set of econometrically determined variables.
This approach, however, has been criticized because cash flows are very
sensitive to business cycles, which may result in overestimating or
underestimating the market value of an institution. Furthermore, in
estimating the cash flows for individual banks, OMB divides all banks into
four groups and estimates parameters, such as cash flow volatility and
loan chargeoffs, for each group. These group parameters are applied to
individual bank earnings in order to project future cash flows. This
introduces correlation among banks in each of the groups when none in
fact may exist. The limitations of OMB’s asset valuation process were
evident from its initial estimates of the parameters, which implied a
negative net worth for all banks. This occurred because the estimation
period included a banking recession. To correct for this, OMB adjusted its
estimates of market values using stock market data on the largest publicly
traded bank holding companies.

The OMB deposit insurance model has also been criticized because it does
not explicitly take into account interest rate risk. The profitability of
banks, thrifts, and credit unions is heavily dependent on both short- and
long-term interest rates. The OMB model implicitly incorporates interest
rate risk and other risks that affect an institution’s profitability through
assumptions made about asset value and volatility of asset earnings.
However, the financial economists we consulted with suggested that
because of the importance of interest rates to the financial health of a
depository institution, explicit modeling of interest rates would be
desirable. Some recent research in the options pricing area incorporates
interest rate risk in an options pricing framework to estimate the
government’s deposit insurance liability.24

Another concern raised by experts is the sensitivity of the deposit
insurance cost estimates generated by OMB’s model to changes in key
assumptions and parameters. Although the sensitivity of a model’s output
to changes in parameter values is not necessarily a negative attribute of a
model, it heightens the need for unbiased assumptions and parameter
estimates. For example, insurance cost estimates generated by OMB’s
model are particularly sensitive to assumptions about the future value of
financial institutions’ assets. Two key assumptions affecting estimates of


23
  Cash generated and used in operations.
24
  See, for example, Jin-Chuan Duan, Arthur F. Moreau, and C. W. Sealey, “Deposit Insurance and Bank
Interest Rate Risk: Pricing and Regulatory Implications,” Journal of Banking and Finance, vol. 19, no.
6, September 1995, pp. 1091-1108.



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future asset values are asset volatility25 and mean-reversion of earnings.26
Analysis of OMB’s model using alternative values for these assumptions
produced significant changes in the estimated cost of deposit insurance.
Using an Office of Thrift Supervision (OTS) estimate of mean-reversion
reduced the government’s estimated 5-year accrued costs by 49 percent
compared to the estimated cost using OMB’s assumptions. Using OTS
estimated standard deviation of thrift assets increased the estimated
5-year cost by 56 percent. The differences in assumptions made by various
financial institution experts and the resulting impact on the cost estimates
demonstrates that additional research on the appropriate assumptions and
parameter values is desirable.

Cost estimates generated by OMB’s deposit insurance model are also highly
sensitive to initial period financial data on depository institutions. OMB’s
model uses only the most recent four quarters of data on an institution’s
earnings to estimate its market value. The model projects the existing
financial condition of institutions into the future and does not account for
wide swings in the general financial health of the industry. As a result,
input data from relatively good economic times will tend to underestimate
future costs, while input data from an economic downturn will
overestimate future costs. For example, using financial data from 1992, a
recessionary year, the OMB model estimated that in 1994 the government
would assume liabilities of $51 billion from failed banks with the cost to
the government being a percentage of this amount. Actual liabilities from
failed banks in 1994 were approximately $1 billion. Forecasting turning
points in the economy is difficult for all forecasters—not only OMB’s
options model—but is one of the major hurdles to generating risk-assumed
estimates for deposit insurance.

Financial economists at bank regulatory agencies were divided in their
views on the use of OMB’s model for accrual-based budgeting. An official at
one agency stated that he did not believe that the model estimates are
valid and reliable enough for budget and policy decisions. Some banking
agency officials expressed concern that the complexity of OMB’s model
made it difficult to replicate and analyze the reliability of the cost
estimates. On the other hand, an official at another banking agency stated
that the concept of accrual-based budgeting makes sense given that once
the government extends the insurance it has already accrued a cost. He
stated further that some estimation uncertainty may be acceptable in the

25
 Asset volatility is the fluctuation over time of the value of an institution’s assets—primarily loans.
Assumptions about future asset volatility are generally based on observed historical volatility.
26
  Mean-reversion of earnings is the tendency of very high or low earnings to revert toward the
industry’s long-term average rate of return.


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                            reported accrual-based cost for deposit insurance in the budget as long as
                            there is a general understanding of the limitations involved. In contrast, he
                            suggested that the same level of uncertainty would not be appropriate for
                            setting insurance premium rates for individual banks.


Other Loss Estimation       Although the OMB options pricing model is the only methodology that
Methodologies for Deposit   directly provides an estimate of the government’s accrued cost of deposit
Insurance                   insurance, alternative models exist that provide forecasts of future bank
                            insolvencies. These forecasts could be used to estimate the government’s
                            accruing costs. Appendix II provides a brief summary of the actuarial,
                            transition matrix, asset markdown, proportional hazards, and pro forma
                            projection models currently being used by various researchers to estimate
                            bank and thrift institution losses.

                            All of the estimation models are limited by their high degree of reliance on
                            professional judgment in setting assumptions and in their use of unaudited
                            call report data. For example, actuarial models generate loss estimates
                            based solely on historical incidence of resolution. Accordingly, the model
                            estimates are highly sensitive to the choice of the historical period used to
                            set these probabilities. For example, at the same time that the financial
                            condition of the bank and thrift industries was improving in recent years,
                            expected future loss estimates based on resolutions during the 1987
                            through 1992 period tended to be very high because they reflected the
                            dismal performance of the industry during this period.

                            Actuarial approaches are also limited in that the effects of only two or
                            three variables can easily be incorporated into the model. Estimates are
                            thus highly sensitive to analysts’ choice of the variables used and the
                            grouping of institutions by these variables. Transition matrix models, a
                            variation of actuarial models, implicitly incorporate more information into
                            loss estimates by using regulatory ratings of financial institutions to
                            estimate the probability of resolution for different categories of
                            institutions. Regulators assign financial institutions a rating to reflect their
                            financial and operating condition, determined through on-site
                            examinations and examiners’ assessment of risk. However, in addition to
                            the limitations described above for all actuarial-based approaches,
                            transition matrix models assume that regulatory ratings are the sole
                            determinant of an institution’s failure.

                            Asset mark-down approaches to estimating the cost of bank and thrift
                            insolvencies are based on the premise that the market value of an



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institution’s assets and equity can be used to identify potentially insolvent
institutions. These types of approaches are limited in that they are very
data intensive, relying heavily on call report data and other data not
readily available for all institutions. For example, some asset mark-down
approaches attempt to discount the cash flows of several categories of an
institution’s assets and liabilities over their expected lives. In addition to
detailed call report data, this process requires information, such as the
maturity or duration of different types of loans, differences between loan
contract and market interest rates, and expected prepayments. Other less
rigorous approaches simply use analysts’ judgments to adjust reported
asset values and earnings growth. Even if these assumptions appear
reasonable, it is difficult to reproduce or verify the adjustments.

Proportional hazard models, another type of econometric approach,
attempt to predict the failure of an institution based on financial
characteristics, regulatory ratings, and economic indicators. As with other
methodologies, the analyst’s ability to identify and measure the variables is
fundamental. Central to proportional hazard models are historical data on
failed institutions and the timing of regulatory action to close the
institutions. Measuring time to failure can be problematic due to the
history of delay in closing many insolvent institutions in the late 1980s.
Use of this type of an approach has generally been limited to short-term
forecasts although some recent research has attempted to forecast failures
over a 5-year period.

Forecasts based on simple projections of current income and capital
levels—pro forma projections—are also highly sensitive to assumptions
and limitations of call report data. Such approaches assume that an
institution’s earnings are its only source of funds and therefore are highly
sensitive to reported income and capital.

The existence and diversity of alternative loss estimation methodologies
for deposit insurance provide a rich body of experience to draw upon in
estimating costs under an accrual-based budgeting approach. However,
such significantly different designs and the widely disparate cost estimates
highlight the difficulty and uncertainty inherent in estimating deposit
insurance costs. The current use of different approaches by federal
agencies will also complicate efforts to reach consensus on the
appropriate method to use to accrue costs in the budget. The uncertainties
and limitations of the various estimation methodologies also underscore
the need to have well-capitalized insurance funds to absorb losses from




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                        failed institutions that are intrinsically difficult to estimate over a
                        long-term period.


                        Methodologies that could be used to estimate the full risk assumed by the
Risk-Assumed            government in insuring private pension plans are not fully developed and
Estimation              validated. However, considerable research and development has been
Methodologies for       invested in two potential approaches—an options pricing approach and a
                        simulation approach. OMB has built upon the work of several academic
Pension Insurance       researchers and applied options pricing theory to estimate the
Not Fully Developed     government’s liability for pension insurance. The Pension Benefit
                        Guaranty Corporation has extended the research of Federal Reserve Bank
and Tested              of New York economists to simulate funding necessary for future plan
                        terminations. Appendix III provides a brief overview of these two
                        estimation approaches.

                        Estimating the cost to the government for the risk assumed in the pension
                        insurance programs is a difficult exercise primarily because it entails
                        forecasting the failure of firms with underfunded pension plans. Firm
                        failure is dependent on a number of economic, industry-specific, and
                        behavioral factors, which are highly uncertain and interrelated. In addition
                        to forecasting firm bankruptcy, estimating the cost of pension insurance is
                        complicated by the need to forecast the financial condition of pension
                        plans. The health of a pension plan is greatly affected by the value of its
                        assets, which depend upon uncertain market conditions and interest rates.
                        In addition, the financial condition of the firm also affects the liabilities of
                        the plan through factors such as employment and benefit levels as well as
                        statutorily defined minimum funding requirements. Under current law,
                        PBGC is allowed to charge plan sponsors a variable premium based only on
                        its level of unfunded vested benefits.


OMB’s Options Pricing   In recent years, OMB has invested significant effort in using options pricing
Approach                theory27 to estimate the government’s cost of federal pension guarantees.
                        The Bush administration’s 1992 accrual budgeting initiative proposed
                        using options pricing methodologies for estimating the accrual costs for
                        both deposit insurance and pension guarantees. In OMB’s pension model,
                        the government’s guarantee is treated as giving the owners of a firm the
                        option to transfer the pension plan liabilities to PBGC when the firm
                        becomes insolvent. This is similar to the concept used by OMB for
                        estimating the cost of deposit insurance. However, since the cost to the

                        27
                          See figure 5.1.



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government for the pension guarantee is contingent on the financial
conditions of both the pension plan and the plan’s sponsoring firm, OMB’s
pension model specifies a probabilistic process for deriving the future
value of both the pension plan’s and the sponsoring firm’s assets and
liabilities.

OMB’s options pricing model for estimating the government’s cost of
pension guarantees requires certain modifications and assumptions that go
beyond common applications of options theory. In most applications of
options pricing, the time to expiration of the option is typically short. As
such, assuming that the value of assets, liabilities, or interest rates will
change at a constant rate over time is not problematic. However, for
pension insurance, the duration of the option is long, making such
standard assumptions unrealistic. For example, the OMB model assumes
that the value of a firm’s assets will vary in the future but always at the
same rate. This assumption is important in determining the future value of
firm and pension assets and, ultimately, the value of the option and the
government’s cost. Experts with whom we consulted pointed out that
common applications of options pricing for long-lived options typically use
probabilistic functions, which allow for large changes in asset values.
Thus, the OMB model potentially could be improved by specifying a
probabilistic process that would allow greater volatility in future asset
values. PBGC officials also noted that OMB’s model does not take into
account Internal Revenue Code rules that specify minimum and maximum
pension plan funding that may dampen actual volatility in the growth of
pension plan assets.

Modifications to the OMB model with regard to its treatment of interest
rates could strengthen its estimation capability. The values of pension
liability are dependent on prevailing and future interest rates because
these liabilities are due in the future. The assumption that future interest
rates are determined today, as assumed in OMB’s model, will cause
inaccuracies—especially in a long-term estimate. The experts that we
consulted also recommended that since interest rate risk has significant
implications for pension liabilities, a separate recognition of interest rate
risk within the OMB model should be considered. Modeling variations in
future interest rates using an appropriate probabilistic process would
introduce variation in a firm’s future pension fund liabilities and
potentially improve estimates of the government’s liability.

Sensitivity analysis performed on the OMB model demonstrated that
assumptions about how much the value of firm and pension plan assets



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                    will vary over time have significant impact on the model estimates. For
                    example, PBGC’s net liability decreased 80 percent when the volatility of a
                    firm’s assets assumed by OMB was cut in half. When volatility estimates
                    derived by other researchers were plugged into the model, the
                    government’s estimated net liability dropped by 92 percent. Such
                    significant differences in the model estimates indicate that additional
                    research on key model parameters and assumptions should be
                    undertaken. Other parameter assumptions, such as the level of net worth
                    at bankruptcy, have also been questioned and should be grounded in
                    empirical research.

                    In addition to the modifications described previously, additional research
                    and development would be necessary before estimates from OMB’s model
                    could be used for accrual-based budgeting. In its current form, the OMB
                    model only generates an estimate of the government’s cost of pension
                    insurance over an indefinite period. In order to use this cost estimate in an
                    annual budget context, a methodology to amortize the cost on a yearly
                    basis is necessary.

                    In discussing OMB’s model with PBGC officials, concerns about the
                    complexity of the model were raised. Even though OMB’s research has been
                    published, and officials have been open in providing researchers access to
                    the model, PBGC’s chief economist characterized the OMB model as a black
                    box. He noted that the model is too complex for most analysts and
                    economists to fully understand and does not provide an intuitive
                    understanding of the factors influencing the government’s cost. In part,
                    these concerns led PBGC to pursue a simulation-based approach to model
                    the financial condition of its insurance program under a range of economic
                    scenarios. PBGC officials asserted that less restrictive computer simulation
                    models are increasingly taking the place of options pricing approaches in
                    financial markets as financial instruments have become more complex and
                    computing power less expensive.


PBGC’s Simulation   Over the last several years, PBGC has been developing a computer
Approach            simulation model, called the Pension Insurance Modeling System (PIMS), to
                    improve its capacity to estimate future claims and evaluate the impact of
                    proposed legislative or regulatory changes on its financial condition. PIMS
                    allows PBGC to model a large number of firm and pension plan attributes,
                    including interest rates, asset returns, and bankruptcy rates, over a wide
                    set of possible economic scenarios. PBGC believes that its simulation
                    approach is a better tool for policy analysis than OMB’s options pricing



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                            model, but agency officials we spoke to were divided over its use for
                            accrual budgeting. OMB has indicated that it would like insurance program
                            agencies to have responsibility for developing accrual-based budget
                            estimates and views PBGC’s PIMS research efforts as a step in that direction.

                            Opinions about the usefulness of PIMS for accrual-based budgeting
                            purposes differ. PBGC’s chief economist expressed concern about using
                            PIMS or any model for accrual-based budgeting purposes. He said that the
                            future expected cost of PBGC’s pension insurance is very sensitive to
                            changes in key assumptions. For example, he said using interest rate
                            experience from the period 1926 to 1991 produces a considerable change
                            in the expected cost compared with using the experience of the 1970 to
                            1991 period. Although the information provided by different simulations is
                            very useful for policy analysis, he does not think it is stable enough for
                            budgeting or accounting. The chief economist suggested that some of his
                            concern could be alleviated if assumptions were set by a neutral body to
                            minimize the potential for manipulation of the cost estimates.

                            PBGC’s chief actuary stated that actuaries look for the best estimate and not
                            the “right” number. He pointed out that all budget estimates are imperfect
                            and PIMS has real value as an estimating tool. Estimating the exposure
                            undertaken by the government is self-correcting—gains and losses over
                            time offset each other. However, if over a number of years gains or losses
                            start adding up and exceed a certain level, then the methodology would
                            have to be reassessed. He stated that this approach has been used by
                            insurance companies to estimate risk-based reserves.


                            The other insurance programs we reviewed—the war-risk insurance
Other Insurance             programs, the Overseas Private Investment Corporation’s (OPIC) political
Programs Also               risk insurance, and the Vaccine Injury Compensation Program (VICP)—will
Present Estimation          likely present significant estimation challenges under an accrual-based
                            budgeting approach. The unique role of these programs, the subjective or
Challenges                  volatile nature of the insured risks, or a lack of relevant historical data
                            complicate risk assessment. According to agency officials, none of these
                            programs currently rely on heavily quantitative or systematic risk
                            assessment tools.


OPIC’s Risk Assessment      OPIC relies heavily on expert judgment to assess the risk it undertakes in
Process Relies Heavily on   insuring investments of U.S. companies abroad against expropriation,
Expert Judgment             currency inconvertibility, and political violence. Although the use of more



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quantitative methods, such as econometric modeling or options pricing,
has been suggested by some budget experts, no specific comprehensive
models have been developed. Further, OPIC officials and some analysts
expressed skepticism about the usefulness of this type of modeling for
OPIC’s insurance activities.


The complexity and subjectivity of political risks along with a lack of
relevant data make risk assessment difficult. Political risks tend to be
country-, industry-, company-, and project-specific. Political risks are
subject to many variables that are inherently difficult to predict, such as
the political stability of governments, long-term macroeconomic
conditions, changes in future foreign relations, or the acceptability of a
given project or industry to the host country. Thus, a risk for one industry
may not be relevant for another industry in the same country. Further,
because there is a lack of empirical evidence, assessment of the potential
implications of various events and conditions is based on primarily
subjective evaluation. An OPIC official stressed that there can be
considerable uncertainty surrounding the business environment and other
factors that influence the risk associated with a particular project. For
example, agency officials stressed that many of the countries covered by
OPIC do not have an extensive history of private sector development and
economic reform programs that would be necessary to develop a useful
model. One official noted that in some areas, such as Eastern Europe and
Russia, there is no historical experience to draw on. Agency officials said
that for these reasons, there are no effective quantitative models or
actuarial tables for OPIC’s political risk insurance.

Currently, the risk assessment methods used by OPIC to set premium rates
and establish insurance reserve levels rely heavily on expert judgment.
However, according to OPIC officials, while the risk assessment process is
not highly quantitative, efforts are made to establish premium rates based
on the risk assumed for a particular project. In determining the risk
associated with a given project, OPIC considers the project-specific risk,
such as the structure of the project and the experience of the project’s
sponsors, and country-based risk, such as projections of the country’s
general economic condition, including balance of payments and foreign
exchange reserve levels. According to OPIC officials, each investment is
negotiated and underwritten individually. They stressed that this process
is important in controlling OPIC’s risk exposure precisely because
predicting political risk over long periods28 is so difficult.


28
  According to OPIC officials, the majority of contracts are written for 20 years.



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OPIC establishes general reserves based on losses inherent in its entire
portfolio. For budget purposes, budget authority is obligated for these
reserves when identified. Reserve levels are developed by OPIC’s
management in consultation with the agency’s independent auditors and
are based on historical experience and an assessment of other factors,
including changes in the composition and volume of the insurance
outstanding and worldwide economic and political conditions. However,
according to agency officials, there is little historical data or 20-year trend
information that can be used to develop actuarial tables to accurately
predict risk. They noted that the program’s entire historical experience is
considered because claims have been sporadic over the life of the program
and no discernable patterns exist. Further, they emphasized that although
historical data provides a starting point, adjustments are made to account
for OPIC’s new business and other factors that affect the level of risk
undertaken. As a result, OPIC officials stressed that management’s
judgment is a key factor in determining the appropriate reserve levels.

OPIC officials expressed serious concerns about the feasibility and
usefulness of generating risk-assumed estimates for budget outlays on
either a project-specific or annual cohort basis. They pointed out that
since only a few (about 150) policies for an even fewer number of projects
are issued each year, adequately pooling risk in any year is extremely
difficult. According to agency officials, a primary concern in minimizing
overall risk is maintaining an appropriate balance across clients, business
sectors, and countries. They stressed that in their opinion, the focus of
management’s efforts and decision-making should be on “good portfolio
management,” such as using contract provisions and client diversification
to mitigate the aggregate risk undertaken by the program. Agency officials
did not believe that a focus on annual cohorts—rather than on OPIC’s entire
portfolio—was conducive to this broad management focus.

Agency officials also noted that a number of factors make determining the
net cost to the government at the time insurance is extended difficult. For
example, they explained that the amount of recoveries associated with
specific projects is very uncertain but not including these amounts would
overstate the government’s potential cost. They also said that it would be
very difficult to determine how to account for and allocate the benefits of
contract provisions that limit total covered losses for multiple projects by
the same company. Overall, OPIC officials said that they strongly opposed
the use of cohort-based budget estimates and were skeptical of whether a
comprehensive risk assessment model for their insurance activities could
be developed. They maintain that their current practice of obligating



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                     reserves based on losses inherent in their portfolio when identified is a
                     reasonable approach.


Unique Role of the   The unique role of the maritime and aviation war-risk insurance programs
War-Risk Programs    complicates risk assessment. The war-risk insurance programs provide
Complicates Risk     insurance to commercial airlines and ship owners during extraordinary
                     circumstances, such as war and other hostilities, in order to support the
Assessment           foreign policy interests of the United States. Both programs provide
                     coverage only when commercial insurance is not available or is available
                     only on unreasonable terms and conditions. This unique role complicates
                     risk assessment because by design (1) the insured risks tend to be
                     case-specific and highly variable, (2) historical program data are limited,
                     and (3) commercial sector war-risk insurance data are unlikely to be
                     directly applicable to the risk assumed by these federal programs.
                     Currently, risk assessment for both programs relies heavily on expert
                     judgment. Neither program uses quantitative modeling or standard risk
                     assessment procedures.

                     Officials from both agencies told us that because of the programs’
                     infrequent activation and extremely rare losses, there is a lack of historical
                     program data for risk assessment. For example, according to Federal
                     Aviation Administration (FAA) officials, aviation war-risk insurance has
                     only been issued during a few brief periods since 1975. Maritime
                     Administration (MARAD) officials also stated that their war-risk insurance is
                     activated very infrequently and remains active for short durations, usually
                     less than a year. Claims under the programs are also extremely rare. In
                     addition, agency officials told us that historical information from
                     commercial war-risk insurance may not be useful in assessing the risk
                     undertaken by their war-risk insurance programs because commercial
                     information often is not readily available or applicable. For example,
                     officials at both agencies told us that premium information is generally not
                     released by commercial sector war-risk insurers.

                     Because of the above limitations, risk assessment for the federal war-risk
                     programs currently relies heavily on expert judgment. Premiums for both
                     programs are set in consideration of the risk involved and U.S. policy
                     interests and to encourage the participation of commercial insurers. In
                     general, risk assessment involves the subjective evaluation of the
                     numerous factors associated with a particular flight or voyage. For
                     example, according to FAA officials, they consider factors such as (1) the
                     hull value, (2) the potential liability for passengers, crew, cargo, and losses



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                         on the ground, and (3) the apparent danger associated with flights into the
                         area(s) excluded by commercial insurers. They told us that in assessing
                         the risks associated with a particular area, they consider available
                         information on potential dangers, such as intelligence information on
                         terrorist groups and the types of weapons involved in the conflict. MARAD
                         officials also described their risk assessment process as ad hoc and
                         subjective. They said that a number of factors are considered in assessing
                         risk, such as (1) the destination of the vessels, (2) the extent of the military
                         threat, (3) the current commercial rates, and (4) the value of the vessels.
                         According to agency officials, an outside consultant, the American
                         War-Risk Agency, has provided advice on risk assessment.

                         Overall, officials from both war-risk programs expressed concerns that
                         accrual-based budgeting may not be feasible for their programs. Officials
                         at both agencies described the infrequent and limited issuance of
                         insurance and the resulting lack of historical experience as key obstacles
                         to developing risk-assumed estimates and using accrual-based budgeting
                         for these programs. The emergency—or stand-by—nature of the programs
                         makes it difficult to know in advance when they will be activated and
                         limits the time available for risk assessment. FAA officials stated that in
                         their opinion it was not feasible to generate reliable risk-assumed
                         estimates for the budget. MARAD officials provided a similar assessment for
                         their war-risk program, stating that given the nature of the program,
                         reliable estimates of the risk assumed could not be developed.


Vaccine Injury           According to Health Resources and Services Administration (HRSA)
Compensation Program’s   officials within the Department of Health and Human Services (HHS),
Limited Historical       systematic risk assessment is not currently undertaken for VICP. The
                         program’s limited historical experience was cited as a key factor in the
Experience May Impede    uncertainty surrounding its future costs. HRSA officials stressed that in
Risk Assessment          their opinion, there is not sufficient historical evidence on the cost of
                         claims to produce meaningful estimates of the program’s future costs
                         because the program has only been in operation since 1989. A 1994
                         Treasury report also concluded that VICP had not been in existence long
                         enough to project future outlays with confidence.29

                         The lack of scientific evidence linking adverse events to vaccines and the
                         dynamic or subjective nature of some variables, such as the amount of
                         settlement awards, have also been cited as factors complicating risk

                         29
                          National Vaccine Injury Compensation Program: Financing the Post-1988 Program and Other Issues,
                         Department of the Treasury, August 1994.



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                          assessment. According to the Treasury study, “the scientific literature
                          indicates that most injuries and deaths of the type compensable under VICP
                          cannot be said with certainty to be caused by vaccinations.”30 In addition,
                          HRSA officials expressed concern that the dynamic or subjective nature of
                          some variables make it difficult, if not impossible, to generate reasonable
                          projections of the program’s future claims. For example, the introduction
                          of new vaccines and the increasing use of combined antigens in a single
                          vaccination make it more difficult to determine risk. Also, HRSA officials
                          described settlement amounts awarded by the courts as case-specific and
                          subjective.

                          Overall, HRSA officials expressed serious reservations about the feasibility
                          of producing reasonable projections of the program’s future costs and the
                          use of accrual-based budgeting for VICP. The Treasury report concurred
                          that until the program matures, program outlays cannot be estimated with
                          confidence, but noted that “as the program matures sufficient program
                          data will become available to permit more sophisticated methods of
                          estimating future outlays to be used.”31 For example, a Treasury analyst
                          noted that it may not be necessary to establish causation between the
                          vaccine and the adverse event in order to establish an estimate of the
                          program’s future outlays. As more cases are settled, it may be possible to
                          establish a pattern between adverse events and award amounts based on
                          historical data. However, changes in variables over time, such as injury
                          coverage and the introduction of new vaccines, will have an impact on the
                          usefulness of cost estimates based on historical data.


                          The ability to generate reasonable, unbiased estimates of the risk assumed
Estimation Challenges     by the federal government is of primary importance in the effective
Are the Critical Factor   implementation of accrual-based budgeting for federal insurance
in Use of                 programs. However, as the discussion in the preceding sections shows, the
                          current development and acceptance of risk assessment methodologies
Risk-Assumed              varies significantly across these programs. This variation reflects the
Estimates                 diversity and nature of the risks insured by the federal government. For
                          some programs, such as the Service Disabled Veterans Life Insurance
                          program, estimates are sufficiently established so that the government’s
                          cost—“the missing premium”—can be reasonably estimated. For other
                          programs, such as deposit insurance, alternative models with different
                          theoretical and practical approaches result in an array of estimates of the
                          government’s costs. Other insurance programs, such as the war-risk

                          30
                            Ibid., v.
                          31
                            Ibid., v.



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insurance and vaccine compensation programs, have no or limited
systematic risk assessment experience. To date, no formal or quantitative
risk assessment methodologies have been established for these programs.
All risk assessment approaches, regardless of their technical
sophistication, are based upon many judgments and the quality and
quantity of available data. As such, assumptions and the process used to
arrive at estimates need to be well documented. In this regard, the use of
econometrics or other quantitative methods can facilitate the replication
of estimates by other analysts and auditors.

The estimation challenges highlighted in this chapter are at the center of
the accrual-based budgeting debate. Within the budget community, there
are a variety of views on the acceptable level of uncertainty and
complexity to introduce into the federal budget. As discussed in chapter 7,
consideration of these issues is likely to be most beneficial when the focus
of the discussion is on whether or not the inclusion of risk-assumed
estimates would provide policymakers with more accurate information
and signals about the underlying insurance programs, rather than on
whether an estimate is the “right” number. It may be most important that
the budget information and incentives provided to policymakers be
“approximately right rather than precisely wrong.”




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Chapter 6

Approaches for Incorporating
Accrual-Based Estimates Into the Budget for
Insurance Programs
                       The way in which accrual-based cost information for federal insurance
                       programs is incorporated into the budget will influence the extent to
                       which budget information and incentives are changed and the limitations
                       of cash-based budgeting are overcome. A key issue surrounding the use of
                       accruals in the budget is the extent to which earlier cost recognition is
                       linked to increased cost control. It is clear that risk-assumed estimates are
                       not yet sufficiently developed to be incorporated directly into the primary
                       budget data—budget authority, outlays, and the deficit. Supplemental
                       reporting of these estimates as they develop would provide policymakers
                       additional information and serve as the basis for future evaluation of
                       whether to incorporate the estimates into the primary budget data. If, over
                       time, reasonable unbiased estimates are developed and a decision is made
                       to use them in the primary budget data, approaches to doing so need to be
                       considered. In this chapter, we examine three general ways of using
                       accrual-based estimates in the budget and their respective advantages and
                       disadvantages.1 In chapter 7, we discuss other issues related to the
                       implementation of accrual-based budgeting for insurance programs.


                       Three general approaches to using accrual-based estimates in the budget
Three General          demonstrate how these measures might be progressively integrated into
Approaches Offer       the primary budget data—budget authority, net outlays, and the budget
Progressive            deficit. Each approach would have a different effect on the aggregate
                       budget totals.
Integration of
Accrual-Based          Supplemental Approach: Under this approach, accrual-based cost
                       measures would be included as supplemental information in the budget
Information Into the   documents. The current basis of reporting budget authority, net outlays,
Budget                 and the budget deficit would not be changed.

                       Aggregate Budget Authority Approach: Under this approach,
                       accrual-based cost measures would be included in budget authority for the
                       insurance program account and in the aggregate budget totals. Net
                       outlays—and hence the budget deficit—would continue to be reported on
                       a cash basis.

                       Aggregate Outlay Approach: Under this approach, accrual-based cost
                       measures would be incorporated into both budget authority and net
                       outlays for the insurance program account and therefore in the aggregate

                       1
                        CBO and OMB discuss several options for incorporating accrual cost measures into the budget for
                       deposit insurance in their respective studies, Budgetary Treatment of Deposit Insurance: A Framework
                       for Reform, Congressional Budget Office, May 1991, and Budgeting for Federal Deposit Insurance,
                       Office of Management and Budget, June 1991.



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                        budget totals. Thus, unlike the other approaches, the budget deficit would
                        include the accrual-based cost for federal insurance programs. This
                        approach is the most comprehensive and would be similar to the approach
                        used for credit programs under credit reform.2


                        Under the supplemental approach, estimates of the risk assumed by the
Supplemental            government would be included in the budget documents as additional
Approach Would          information. Given the existing state of the art in making accrual-based
Retain Current Basis    estimates, this approach is the most feasible at this time. The current basis
                        of reporting budget authority, net outlays, and the deficit would not be
of Budget Reporting     changed. Including accrual-based information in the budget to supplement
for Federal Insurance   the traditional cash-based budget reporting for federal insurance programs
                        would increase the information available to decisionmakers by helping to
Programs                highlight the potential costs of these programs. This approach would also
                        allow time to test and improve estimation methodologies and increase the
                        comfort level of users before considering whether to move to a more
                        comprehensive approach. In a similar fashion, information on federal
                        credit programs and estimates of the government’s subsidy costs were
                        reported for years in the Special Analyses volume of the President’s
                        budget prior to the enactment of credit reform.

                        However, this approach might not have a significant impact on the budget
                        decision-making process because the accrual-based cost information
                        would not directly affect the budget totals and the budget allocations to
                        congressional committees. Furthermore, there may be little incentive to
                        improve cost estimates and/or risk assessment methodologies for the
                        various insurance programs since this information would not be the basis
                        for budget decisions. Figure 6.1 provides a summary of the key advantages
                        and disadvantages of the supplemental information approach.




                        2
                         Appendix I provides an overview of the treatment of direct loans and loan guarantees under credit
                        reform.



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Figure 6.1: Advantages and Disadvantages of the Supplemental Approach


        Advantages

        •   Provides earlier disclosure of insurance costs in budget documents.

        •   Retains the current basis of reporting, which is relatively straightforward and
            understandable.

        •   Uses the same reporting basis for federal insurance programs as most other federal
            programs.

        •   Allows time to develop, test, and improve estimation methodologies.

        •   May be used to smooth transition to more comprehensive approach.

        Disadvantages

        •   May not significantly influence the budget decision-making process because
            accrual-based costs are not incorporated directly into primary budget data.

        •   May not prompt sufficient efforts to improve cost estimates because accrual-based
            costs are not the basis of budget decisions.




                                         Accrual-based costs for federal insurance programs could be presented as
                                         supplemental information in the budget in a number of ways. In recent
                                         years, OMB has provided some risk-assumed cost information on insurance
                                         programs in the Analytical Perspectives volume of the President’s Budget.3
                                         This presentation could be continued and enhanced by developing a
                                         consistent format for reporting the risk assumed by each program.

                                         Useful information for this type of presentation, some of which has been
                                         presented in previous budgets, includes (1) the annual risk-assumed cost
                                         for each program, (2) summaries of the methodologies used to generate
                                         cost estimates, and (3) explanations of any changes in estimates from year


                                         3
                                         For example, see chapter 8, “Underwriting Federal Credit and Insurance,” Analytical Perspectives,
                                         Budget of the United States Government, Fiscal Year 1997.



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                     to year. Two key advantages of this type of presentation are (1) a more
                     detailed narrative discussion is possible than in the account-level
                     presentation of the budget appendix and (2) all federal insurance
                     programs are discussed in one place.

                     Such a discussion could be further supplemented if accrual-based cost
                     information was also displayed at the insurance program account level in
                     the budget appendix even though it would not be included in the budget
                     totals. For example, the cost of insurance programs could be shown on an
                     accrual basis in one table for display purposes and on a cash basis in
                     another table for the same account. Although only the cash-based amount
                     would be included in the budget totals, this presentation may increase
                     attention paid to risk-assumed cost estimates at the time budget decisions
                     are made. Such a display would highlight the differences in the type of
                     information provided on a cash basis versus an accrual basis for the
                     various insurance programs without changing the reporting basis of total
                     budget authority, net outlays, or the budget deficit.


                     The aggregate budget authority approach moves further along the
Aggregate Budget     continuum from cash-based budgeting to full accrual-based budgeting.
Authority Approach   This would incorporate accrual-based cost measures into budget authority
Would Introduce      but would stop short of adopting the full credit reform approach. The full
                     cost of the risk assumed by the government would be recognized in the
Some Accrual         budget authority for the insurance program and the aggregate budget
Amounts Into the     authority totals. Net outlays and the budget deficit would continue to be
                     reported on a cash basis. Budget authority would be obligated at the time
Budget               an insurance commitment was made and would be held as a reserve in the
                     program account earning interest. Future claims would be paid from the
                     authority in these reserves.

                     A key advantage of the aggregate budget authority approach is that it
                     provides earlier recognition of insurance costs directly in the budget (in
                     budget authority) while preserving cash-based reporting for net outlays
                     and the deficit. Recognizing accrual cost estimates in budget authority
                     may increase attention to these costs without potentially subjecting
                     outlays and the deficit to estimation uncertainty. This increased attention
                     may also focus efforts on improving cost estimates. However, since the
                     accrual-based cost would not be reflected in the budget deficit, it is
                     unclear how much more this approach would affect the budget
                     decision-making process than the supplemental information approach.




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Figure 6.2 presents a summary of the key advantages and disadvantages of
the aggregate budget authority approach.




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Figure 6.2: Advantages and Disadvantages of the Aggregate Budget Authority Approach


        Advantages

        •   Recognizes cost directly in the budget as budget authority at the time insurance
            commitments are made.

        •   Retains cash-based reporting for net outlays and budget deficit, which is relatively
            straightforward and understandable.

        •   Increases budget recognition and the likelihood of controlling annual program costs
            as compared to the supplemental approach.

        •   Removes program cost distortions and perverse budget scoring incentives for
            budget authority.

        •   May be used to recognize the cost of establishing reserves for high or catastrophic
            loss years and reduce the possibility of unintended subsidy costs.

        •   May be used to smooth the transition to a more comprehensive aggregate outlay
            approach.

        Disadvantages

        •   Recognition of costs in budget authority alone may not significantly influence the
            budget decision-making process.

        •   Recognition of cost in budget authority does not address the cost distortions and
            perverse scoring incentives for outlays that can occur on a cash basis.

        •   Outlays and the deficit will continue to reflect cash flows rather than focusing
            attention on the cost of new insurance commitments.

        •   Impact of temporary or sporadic cash flows on the deficit would not be moderated.

        •   There may be an incentive to divert reserves to other purposes (see chapter 7).

        •   The reporting of budget authority on a risk-assumed basis and outlays on a cash
            basis may be confusing.




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                          The influence of this approach is likely to be further limited by the fact
                          that most federal insurance programs are classified as “mandatory” under
                          BEA.4 This means that only increases in budget authority caused by
                          changes in legislation must be addressed by the Congress. Although this is
                          also true for automatic increases in outlays, the fact that changes in
                          outlays increase the deficit could prompt action. The budget authority only
                          approach does not offer this incentive. The potential impact of this
                          approach on the decision-making process would likely be greater for
                          insurance programs that are classified as discretionary spending because
                          accrued costs would be included under the discretionary budget authority
                          spending caps. As discretionary budget authority totals near the
                          discretionary spending limits, this approach may prompt the Congress to
                          specifically address the costs of these programs.5


A Discretionary Feature   Actions to control costs under the aggregate budget authority approach
Combined With Aggregate   could be prompted by requiring a discretionary appropriation for the
Budget Authority          government’s subsidy cost. For insurance programs classified as
                          mandatory, a separate discretionary account would be created to record
Approach Could Prompt     the government’s subsidy costs. A general fund appropriation to the
Action to Address Costs   discretionary account would be required to cover any subsidy costs in the
                          year the insurance is extended, unless alternative actions were taken to
                          reduce the government’s cost, such as increasing program collections or
                          reducing future program costs. Amounts appropriated to the discretionary
                          account would then be paid to a mandatory program account. The
                          mandatory program account would handle all other cash flows including
                          premium collections and claim payments. This account would also hold
                          the program’s reserves for future claims. As a result, the government’s
                          accrual-based costs would be reported in the budget authority and net
                          outlays for the program’s discretionary account and in the budget
                          authority totals for the government. Total net outlays and the budget
                          deficit would continue to be recorded on a cash basis.

                          Figure 6.3 demonstrates how the cost of a hypothetical insurance program
                          would be recorded under this approach, assuming that a funding




                          4
                           As noted in chapter 2, claim payments for 10 of the 13 programs reviewed are classified as mandatory
                          spending.
                          5
                           CBO estimates that the President’s fiscal year 1998 discretionary spending proposals will be
                          approximately $4 billion below the budget authority spending caps.



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                                          deficiency exists on an accrual basis. The insurance program is assumed
                                          to have the following activity:6

                                          (1) premium collections of $5 billion;

                                          (2) claim payments of $3 billion; and

                                          (3) an accrual-based subsidy cost to the government of $4 billion, i.e., an
                                          estimated funding shortfall between the risk assumed and estimated
                                          collections.



Figure 6.3: Reporting Flow for the Budget Authority Approach With Discretionary Option



  Insureds
                                                   Premiums $5 billion



                 Discretionary                                                                                           Mandatory

               Subsidy account                                                                           Program account

                                                                                                   Premium receipts: $5 billion
                                          Accrual-based subsidy costs $4 billion
             Appropriation: $4 billion                                                              Claim payments: $3 billion
                                                Intragovernmental transfer                        Negative net outlays: $2 billion
                                                                                              Intragovernmental transfer: $4 billion
              Net outlays: $4 billion
               (Intragovernmental)                                                                     (Reserves: $6 billion)



                                                 Claim payments $3 billion




                                          As shown in Figure 6.3, the mandatory program account would record
                                          cash flows, including $5 billion in premium collections and cash outlays of

                                          6
                                           Administrative costs have been omitted for simplicity. In practice, some insurance programs are
                                          designed to cover administrative costs while the administrative costs of others are paid from general
                                          fund appropriations. The treatment of administrative costs should be considered in the development
                                          and implementation of accrual-based budgeting for these programs. For example, if the intention is for
                                          the program to be completely self-supporting, then administrative costs should be covered by program
                                          collections and could be paid from the financing account to the program account. Alternatively, if
                                          administrative costs are covered by general funds, they could be separately appropriated to the
                                          program account.



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$3 billion for claim payments. The accrual-based subsidy cost of $4 billion
would be appropriated to the discretionary account and then transferred
to the mandatory account. As a result, the subsidy cost of $4 billion would
be scored against the discretionary spending caps and, negative outlays of
$2 billion would be recorded in the mandatory program account and
included in the deficit. Reserves of $6 billion would be held in the program
account as obligated budget authority invested in Treasury securities.

A key advantage of this approach is that it prompts budget decisionmakers
to address explicitly the government’s cost while preserving the more
straightforward cash-based reporting for net outlays and the budget
deficit. Since the appropriation would be discretionary, and thus subject to
BEA caps (assuming their extension), decisionmakers would have an
incentive to reduce the government’s costs. Despite this advantage,
however, there are broader policy considerations involved with creating a
discretionary aspect for programs originally funded as mandatory
spending.7 In most cases, such a step would go beyond simply changing
the reporting of program costs in the budget by shifting the locus of
decisions to the annual appropriation process thereby possibly changing
program operations. Figure 6.4 summarizes the key advantages and
disadvantages of this feature.




7
 Claim payments for 10 of the 13 insurance programs included in this study are classified as mandatory
spending under BEA.



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Figure 6.4: Advantages and Disadvantages of the Aggregate Budget Authority Approach With Discretionary Outlay Feature


        Advantages

        •   Recognizes cost directly in the budget at the time insurance commitments are
            made.

        •   Provides an additional level of budget control.

        •   Reports net outlays and the budget deficit on a cash basis, which tends to be
            straightforward and easy to understand.

        •   All cash flows from insurance programs would be included in budget totals.

        •   Improves the relative cost information for federal insurance programs.

        •   May be used to smooth the transition to a more comprehensive approach.


        Disadvantages

        •   Requires a fundamental change in the nature and operations of most federal
            insurance programs.

        •   May increase incentive for manipulating cost estimates due to pressure of
            discretionary spending caps.

        •   Does not eliminate the distorting effects of temporary or erratic cash flows on the
            deficit.

        •   Increases the complexity of the program's budget treatment.




                                         The aggregate outlay approach is the most far-reaching of the three
Aggregate Outlay                         general approaches outlined. This approach is similar to both the
Approach                                 treatment of credit programs under credit reform and the approach
Incorporates Accruals                    proposed by OMB for federal insurance programs in the fiscal year 1993
                                         budget. Under this approach, accrual-based costs would be recorded in
Into the Primary                         both budget authority and outlays for the program and in the aggregate
Budget Data                              budget totals, including the budget deficit.




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                                  Like credit reform, two key features of this approach include (1) the use of
                                  a program account and a financing account8 and (2) the separation of
                                  insurance program activities into transactions that represent a cost to the
                                  government and transactions that are merely cash flows with no cost to
                                  the government, such as working capital transactions. The government’s
                                  accrual-based subsidy cost for an insurance activity would be recorded in
                                  the program account while all other cash flows would be handled in a
                                  separate financing account. Similar to credit reform, the program account
                                  would be budgetary and thus included in the calculation of the budget
                                  deficit. The financing account, on the other hand, would be a
                                  nonbudgetary account9 and thus not included in the deficit calculation.
                                  Table 6.1 illustrates the relationship between these accounts, the budget
                                  deficit, and the government’s borrowing needs.

Table 6.1: Relationship Between
Budgetary and Nonbudgetary
Accounts                          Budgetary accounts                  Total Governmental Receipts
                                                                      minus
                                                                      Net Outlays
                                                                      equals
                                                                      Deficit (or Surplus)
                                  Nonbudgetary accounts               minus
                                                                      Means of Financing
                                                                      equals
                                                                      Borrowing From the Public
                                  Source: Budgetary Treatment of Deposit Insurance: A Framework for Reform, Congressional
                                  Budget Office, May 1991.



                                  Under this approach, the accrued cost to the government would first be
                                  recognized in the program account and then outlayed to the nonbudgetary
                                  financing account. This transaction will cause the government’s
                                  accrual-based subsidy cost to be included in the deficit at the time the
                                  insurance is extended. Therefore, the measurement basis of outlays for the
                                  program account and deficit would be changed from the current cash

                                  8
                                   A third account, a liquidating account, may be used for some insurance programs to handle
                                  transactions that occur prior to changing to the new budget treatment. Chapter 7 discusses the use of a
                                  liquidating account.
                                  9
                                   Nonbudgetary accounts appear in the budget document for information purposes but are not included
                                  in the budget totals for budget authority or outlays. They account for transactions of the government
                                  that do not belong within the budget because they are means of financing and do not represent a cost
                                  to the government. Nonbudgetary transactions include deposit funds such as state and local income
                                  taxes withheld from federal employee salaries, direct and guaranteed loan financing accounts, and
                                  seigniorage.



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                                     basis to an accrual-based estimate of the government’s subsidy cost for an
                                     insurance activity. An appropriation would cover the government’s cost
                                     unless other actions were taken to eliminate the funding shortfall, such as
                                     increasing collections or reducing program costs. Since most insurance
                                     programs are mandatory, this appropriation10 would occur automatically
                                     unless additional control mechanisms, as discussed previously, were
                                     adopted. Even without this additional feature, the fact that increases in
                                     outlays would be reflected in the deficit could prompt action to address
                                     the causes of such increases. Key factors involved in implementing this
                                     general approach, including reestimation, funding sources, and reserve
                                     levels, are discussed in chapter 7.

                                     Figures 6.5 and 6.6 compare how the cost for the hypothetical insurance
                                     program outlined above would be recorded under the current cash-based
                                     approach versus the aggregate outlay approach.


Figure 6.5: Reporting Flow for the
Current Cash-Based Approach
                                                                       Premiums $5 billion
                                          Insureds




                                                 Claim payments $3 billion                         Insurance fund



                                                                                        Negative net outlays (cash income)
                                                                                                     $2 billion




                                     As shown in figure 6.5, the current cash-based budget would record cash
                                     inflows of $5 billion and cash payments of $3 billion, resulting in negative
                                     net outlays (income) of $2 billion. Total net outlays and the budget deficit
                                     would be reduced by this amount in the current budget period.
                                     Conversely, as shown in figure 6.6, under the aggregate outlay approach,
                                     the insurance program would receive an appropriation to reflect the

                                     10
                                       For mandatory programs, this would be a permanent appropriation.



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                                         subsidy on a risk-assumed basis, unless some alternative actions are taken
                                         to eliminate the funding shortfall. An appropriation of $4 billion would be
                                         received by the program account and outlayed to the financing account.11
                                         This amount would be included in total net outlays and the budget deficit.
                                         The financing account would also record nonbudgetary cash flows,
                                         including premium income of $5 billion and claim payments of $3 billion.
                                         As a result, under this approach, the insurance program would increase
                                         the budget deficit by $4 billion rather than reducing it by $2 billion, as was
                                         the case on a cash basis.



Figure 6.6: Reporting Flow for the Aggregate Outlay Approach


                                                             Premiums $5 billion
  Insureds
                                                               (Nonbudgetary)


                   Budgetary                                                                                                 Nonbudgetary

               Program account                                                                                 Financing account


                                                    Accrual-based subsidy costs $4 billion
             Appropriation: $4 billion                                                                         Reserves: $6 billion
                                                                 (Budgetary)


              Net outlays: $4 billion



                                                          Claim payments $3 billion

                                                               (Nonbudgetary)




                                         11
                                           In the past, OMB and CBO have differed on the treatment of premiums in discussing a credit reform
                                         approach for deposit insurance. Under OMB’s approach, premium collections flow into the financing
                                         account as described above. This approach is justified because these funds are a means of financing
                                         deposit insurance and are not available to fund other federal programs. Under CBO’s approach,
                                         premiums would be credited to the program account and then transferred to the financing account.
                                         CBO argues that this approach adheres more closely with the budget’s current treatment of insurance
                                         premiums as offsetting collections. In addition, CBO notes that if premiums are credited to the
                                         financing account, then the program account would only report activity when it received an
                                         appropriation for accrual-based losses in excess of program funding sources. We believe that if the
                                         aggregate outlay approach were adopted, the current treatment of premiums would need to be
                                         changed, similar to the changes made by credit reform for the reporting of loan repayments.



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Without fundamentally changing the nature of most federal insurance
spending, the aggregate outlay approach is the most comprehensive of the
three approaches outlined and has the greatest potential to achieve many
of the conceptual benefits of accrual-based budgeting. The isolation and
recognition of the government’s full cost when budget decisions are being
made would permit more fully informed resource allocation decisions. By
recognizing the government’s cost in the budget deficit at the time
decisions are made, the incentives for managing insurance costs may be
improved. Furthermore, recognizing costs in net outlays and the deficit at
the time insurance commitments are made would better reflect their fiscal
effects. In some cases, such as for the deposit insurance programs,
accrual-based budgeting using the aggregate outlay approach may smooth
spending patterns and reduce cost distortions created by temporary or
sporadic cash flows.

Despite these potential advantages, the aggregate outlay approach has
several disadvantages. A primary concern is the uncertainty surrounding
the estimates of the risk assumed by the federal government for federal
insurance programs. To the extent that estimates are unreliable, resource
allocation may be distorted and the potential for manipulation increased.
As discussed in chapter 5, risk-assumed cost estimates for most insurance
programs are either currently unavailable or not fully accepted and thus
the uncertainty surrounding these estimates presents a key obstacle to the
successful implementation of this approach. In addition, the aggregate
outlay approach adds a layer of complexity to an already complex budget
process. As was the case with credit reform, the use of accrual-based
budgeting for federal insurance programs will result in new complexities
and implementation challenges.

Further, unlike the majority of programs covered under credit reform,
most federal insurance spending is classified as mandatory under BEA. As
discussed above, under BEA for mandatory programs, only legislated
changes that increase the level of the government’s commitment would
have to be offset by spending reductions or revenue increases. Increases in
existing spending for mandatory federal insurance programs would not
require action to address these costs, but the inclusion of accrued costs in
the deficit calculation may provide more incentive to address them than
the aggregate budget authority approach. Figure 6.7 summarizes the key
advantages and disadvantages of the aggregate outlay approach. If
additional budget control is desirable, a discretionary appropriation could
be required to fund the government’s accrued subsidy cost unless other
corrective action is taken. But doing so would go beyond merely changing



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the reporting of program costs in the budget by shifting the locus of
decisions to the annual appropriation process, thereby possibly changing
program operations.




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Figure 6.7: Advantages and Disadvantages of the Aggregate Outlay Approach



     Advantages

     •   Recognizes the government's cost for insurance activities in outlays and the deficit at the time
         commitments are made.

     •   Permits better informed budget decisions by isolating the cost of the government's commitments
         when budget decisions are made.

     •   Removes perverse budget scoring incentives and may improve incentives for managing program
         costs by recognizing the government's cost in the budget deficit at the time decisions are made.

     •   Better reflects the timing and magnitude of the fiscal impact of federal insurance programs.

     •   May be used to establish reserves for high or catastrophic loss years and thus reduces the
         possibility of unintended subsidy costs.

     •   May smooth spending patterns and reduce distortions created by temporary or sporadic cash flows,
         in some cases by recognizing annual accrual-based costs.

     •   May increase the difficulty of diverting reserves for other budget purposes by using a nonbudgetary
         financing account.

     Disadvantages

     •   Budget totals, including the budget deficit, would include cost measures based on complex
         calculations that are not as well understood as cash.

     •   Using estimates in the “actual” budget totals would increase the uncertainty surrounding these
         numbers and would require that a process be established to make future reestimates.

     •   In some cases, estimation uncertainty and volatility may lead to swings in the budget deficit.

     •   Budget reporting would be more complex.

     •   If premiums are credited to the financing account, then the budgetary program account would only
         record activity when the program receives a subsidy.

     •   The difference between the reported budget deficit and the government's borrowing needs would
         increase.

     •   The degree of change in budget incentives would depend on the link between the cost recognition
         and budget control mechanisms, such as premium increases, because the majority of the programs
         are classified as mandatory spending.



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                       The various approaches to incorporating accrual-based information into
Different Approaches   the budget have different effects on the information and incentives
to Accrual-Based       provided to decisionmakers. As noted previously, earlier cost recognition
Budgeting Have         under any of the three general approaches would not necessarily mean
                       that action would be taken to address costs. In fact, the supplemental
Different Impact on    approach may have little, if any, effect on budget decision-making. The
Information for        extent to which earlier cost recognition under the other two general
                       approaches prompts action to address accruing cost depends primarily on
Budget Decisions       whether the program has permanent budget authority12 and is classified as
                       mandatory spending. Since most insurance programs have permanent
                       budget authority and are classified as mandatory, even the most
                       comprehensive general approach—the aggregate outlay approach—would
                       not necessarily require any action to be taken without the adoption of
                       additional budget control mechanisms. It would, however, make more
                       visible any increase in costs.

                       While earlier reporting of accrual-based costs in net outlays and the
                       budget deficit might prompt deficit reduction efforts, nothing in the
                       current budget process would require that the cost of insurance programs
                       specifically be addressed as long as permanent authority was available to
                       cover these costs. The earlier recognition would, however, increase
                       control over legislated changes that increase future costs because, under
                       PAYGO, legislation enacted during a session of the Congress affecting
                       mandatory programs must be at least deficit neutral in the aggregate.
                       Under both the budget authority and outlay approach, mechanisms could
                       be developed to increase the link between earlier cost recognition and
                       budget control. For example, requiring the accrued cost to be funded by
                       discretionary appropriation13 would increase budget control because these
                       costs would be forced to compete for limited resources under the
                       discretionary spending caps. Alternatively, mechanisms that link funding
                       shortfalls to premium increases or program coverage reductions could
                       also be adopted.

                       Whether it is desirable for cost recognition automatically to trigger
                       congressional action is a policy question. Consideration of the varied
                       purposes and characteristics of these programs should inform the
                       discussion on whether to adopt a trigger mechanism, and if so, how to

                       12
                         Permanent budget authority refers to authority derived from previous authorizing legislation rather
                       than annual appropriation acts.
                       13
                         Under BEA requirements, discretionary spending is subject to spending limitations, referred to as
                       “caps.” As noted earlier, claim payments for only three of the insurance programs reviewed—Aviation
                       War-Risk, Maritime War-Risk, and OPIC’s political risk insurance—are classified as discretionary
                       spending. Claim payments for all of the other federal insurance programs are mandatory.



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                                                 design it. For example, requiring a discretionary appropriation would
                                                 result in a fundamental change in the nature and operation of the majority
                                                 of federal insurance programs that were originally classified as mandatory
                                                 spending. The various approaches reflect trade-offs between changing
                                                 budget incentives and other policy considerations. Table 6.2 provides an
                                                 assessment of the relative potential of each approach to influence budget
                                                 decision-making.


Table 6.2: Assessment of Accrual-Based Budgeting Approaches to Influence Budget Decision-making
                                                               Approaches to accrual-based budgeting
                                                                                          Aggregate
                                                                                          budget                                Aggregate
                                                                          Aggregate       authority with                        outlay with
Influence of change in budget treatment on                                budget          discretionary         Aggregate       discretionary
budgeting                                             Supplemental        authority       appropriation         outlay          appropriation
Better cost information would be available for        X                   X               X                     X               X
potential use
Reserves would be established for future costs                            X               X                     X               X
                                                                                                                 a
Recognition would prompt action to address                                                X                     X               X
accruing program costs
                                                 a
                                                  Unlike the approaches requiring a discretionary appropriation, this approach would not achieve
                                                 direct budget control for mandatory insurance programs but rather would influence budget
                                                 decision-making through its impact on the deficit.



                                                 In summary, the supplemental approach would improve and provide more
                                                 consistent disclosure of estimates of risk-assumed costs in the budget
                                                 documents than is currently the case and might cause discussion, but it
                                                 would not directly influence the budget incentives for these programs. The
                                                 aggregate budget authority approach goes a step further and begins to
                                                 incorporate accrual-based costs into the budget process by requiring the
                                                 provision of budget authority at the time decisions are made. However,
                                                 because accrual-based costs do not affect the “bottom line” or the budget
                                                 deficit, the impact of this approach on budget decision-making is unclear.
                                                 The aggregate outlay approach goes even further by incorporating costs
                                                 directly into the deficit calculation and therefore is more likely to
                                                 influence budget decisions than the aggregate budget authority approach.
                                                 But direct budget control is not achieved for the majority of federal
                                                 insurance programs, which are classified as mandatory spending. Under
                                                 either the aggregate budget authority or the aggregate outlay approach,
                                                 requiring a discretionary appropriation for the government’s subsidy costs
                                                 would provide direct budget control.




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                         As shown in table 6.2, the aggregate outlay approach and the two
                         approaches using a discretionary control option are most likely to prompt
                         action to address accruing program costs. However, under current budget
                         rules, the incentives provided by each differ. Requiring a discretionary
                         appropriation under the aggregate outlay approach would have the most
                         influence on budget decision-making by affecting both the deficit and the
                         discretionary spending caps. Under the aggregate budget authority
                         approach with a discretionary control option, cost would have to be
                         included under the discretionary spending caps but would not affect the
                         deficit. As discussed earlier, if changing the locus of budget
                         decision-making for these programs and thereby possibly affecting
                         program operations is undesirable, then the aggregate outlay approach,
                         through its impact on the deficit, has the greatest potential to influence
                         budget decision-making.


                         Within the budget community there exists a range of views about the
Approaches Reflect       appropriate balance between the need to change budget information and
Differing Views on the   incentives for federal insurance programs and the increased uncertainty
Use of Accrual-Based     and complexity introduced by the use of accrual-based estimates directly
                         in the budget. The various approaches to incorporating accrual-based
Information in           information in the budget discussed above represent a spectrum of views
Budgeting for Federal    about the uses of the federal budget and the trade-offs faced in using
                         accrual-based information in budgeting for federal insurance programs.
Insurance Programs
                         The aggregate outlay approach reflects the opinion of some budget
                         experts that the only way to influence budget decision-making
                         significantly is to have a direct impact on the “bottom line” or the budget
                         deficit. The key argument is that since the primary focus of the budget
                         debate is the deficit, accrual-based reporting will not significantly
                         influence budget decisions unless these costs are part of the deficit
                         calculation. The use of a financing account to separate costly transactions
                         and noncostly cash flows14 focuses reporting on the government’s subsidy
                         cost. And, in the opinion of some budget experts, this increases the
                         difficulty of diverting to other uses the funding accumulated as reserves.

                         The aggregate budget authority approach reflects both general concerns
                         about the use of the nonbudgetary financing mechanisms and specific
                         concerns that the aggregate outlay approach may not be necessary for

                         14
                           As discussed in chapter 3, most federal insurance programs have costly and noncostly transactions.
                         For example, while claim payments in excess of program collections for an insurance activity
                         represent a cost to the government, other cash flow imbalances may be temporary and net out over
                         time.



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some federal insurance programs. Despite the potential benefits of
accrual-based information, a key reservation surrounding the adoption of
the aggregate outlay approach is its use of nonbudgetary financing
accounts. As a general point, some experts believe that all cash
transactions should be included in the budget totals and that cash is a
superior measure for the deficit because it is understandable and relatively
transparent. Specifically, concerns have been expressed that the use of
nonbudgetary financing accounts introduces new risks and may increase
the incentive for cost manipulation. For example, estimates could be
manipulated to obscure the potential program costs or the deficit if
estimation methodologies are not widely accepted and documented. The
uncertainty surrounding the risk-assumed cost estimates for some
insurance programs increases these concerns. Thus, until estimation
techniques are developed sufficiently to allay most of these concerns, the
aggregate budget authority approach may be the most appropriate way to
implement accrual-based budgeting for federal insurance programs.

In addition, some agency officials, budget experts, and analysts expressed
concerns that the use of the aggregate outlay approach would increase the
complexity of the budget reporting. According to some budget experts,
budget authority and obligations are more appropriate than outlays for
recognizing potential costs that have not yet materialized and that for
some programs the costs of implementing the aggregate outlay approach
would outweigh the potential benefits. Budget experts also differ on the
use of discretionary spending mechanisms to increase budget control. One
budget expert emphasized that requiring a discretionary appropriation for
subsidy costs under the budget authority approach would increase budget
control while preserving cash-based reporting of outlays and the deficit.
However, other budget experts cautioned against changing the
fundamental nature of mandatory federal insurance spending by requiring
a discretionary appropriation under either the budget authority or outlay
approach. For example, OMB has stressed that the goal of its previous
proposal was not to change the nature of the spending but rather to
improve the budget reporting for these programs.

Finally, the supplemental approach reflects the view that cash is the
superior measure for budget decision-making or that the shift to
accrual-based budgeting for federal insurance programs is premature or
unnecessary. A key argument is that supplemental information can be
used to improve budget decisions without subjecting the budget to any
additional uncertainty or complexity. However, with this approach, there




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is no guarantee that the information will be used since it is not a part of
the formal budget process.

Any choice among these approaches or variants of them is further
complicated by the fact that the relative implementation difficulties—and
the benefits achieved—vary across federal insurance programs. The
trade-offs and implementation challenges associated with adopting accrual
measures in the budget are discussed in the next chapter.




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                           Although accrual-based budgeting for federal insurance programs has the
                           potential to improve the information available for resource allocation and
                           fiscal policy decisions, implementing an accrual-based approach will
                           present policymakers, budget professionals, and agency managers with
                           many challenges. As discussed in chapter 5, the key implementation issue
                           is whether reasonable, unbiased risk-assumed cost estimates can be
                           developed for the insurance programs. However, generating cost estimates
                           is only the first step in implementing accrual-based budgeting. Other
                           significant challenges exist that would need to be addressed in
                           implementing an accrual-based budgeting approach. These challenges fall
                           into three broad categories: (1) issues inherent in the use of risk-assumed
                           estimates in the budget, (2) short-term implementation issues that may be
                           reduced or eliminated over time, and (3) issues related to the design and
                           structure of an accrual-based budgeting system.


                           One of the major benefits of accrual-based budgeting is the
Issues Inherent in the     recognition—when programmatic and funding decisions are being
Use of Accrual             made—of the cost of future insurance claims related to the government’s
Estimates in the           insurance commitment. This earlier recognition of costs improves the
                           information available to policymakers about their decisions and may
Budget                     improve the ability and incentives to manage these costs. However, as
                           discussed, this earlier recognition of program cost is dependent upon
                           reasonable, unbiased estimates of the risk assumed by the government in
                           undertaking the insurance commitment. Because insurance program costs
                           are dependent upon many economic, behavioral, and environmental
                           variables, which cannot be known with certainty in advance of the insured
                           loss, there will always be uncertainty in the reported accrual-based
                           estimates. In addition, the use of risk-assumed cost estimation
                           methodologies that attempt to capture the effects of these variables and
                           new budget mechanisms to report estimates and reestimates will add
                           complexity to budget reporting for these programs.


Earlier Cost Recognition   While budgeting based on estimates of the full cost of the risk assumed by
Increases Estimation       the government for federal insurance programs has the potential to
Uncertainty                improve the information available to policymakers at the time budget
                           decisions are being made, actual claims paid in any one year will differ
                           from the estimated cost of the commitments reported in the budget. This
                           is an expected condition of using risk-assumed accrual cost estimates in
                           the budget for insurance programs. Although estimates may get more
                           accurate over time due to improvements in estimation methodologies,



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available data, and assumption specification, some error will always
remain. Policymakers need to understand the nature and extent of the
uncertainty in risk-assumed cost estimates and have assurances that the
estimates are unbiased and based on the best available information and
estimation methodologies.

The uncertainty embedded in estimates of the risk assumed by federal
insurance programs is unavoidable. As discussed in earlier chapters, the
nature of the risks covered by some federal insurance programs require
that the risks be pooled over time. As a result, the expected long-term cost
of the program reflected in the risk-assumed cost estimates will differ
from the cash paid out in any given year. Reestimates will probably also be
required over time if the program’s claim experience differs significantly
from the previously calculated expected long-term cost. Improved
program data could also lead to reestimates.

The uncertain nature of risk-assumed cost estimates must be weighed
against potential improvements in budget reporting and cost control. A
similar trade-off was made in budgeting for credit programs under the
Federal Credit Reform Act of 1990. Although the accrual-based cost
estimates of some loan and loan guarantee programs have significantly
changed and their actual cost may not be known for 20 or more years,
most budget experts believe that the budgeting for these programs has
been improved. Specifically, by improving information and the recognition
of program costs, accrual-based budgeting for credit programs has
increased control over credit program costs, improved comparisons of the
costs of credit program with that of other programs, and subjected credit
programs to the competitive allocation of resources in the budget process.
An accrual-based budgeting approach for insurance programs also has the
potential to provide an opportunity to consider the appropriate or desired
amount of government funding—or subsidy—provided to a particular
program. Risk-assumed cost estimates would also allow policymakers,
oversight agencies, and program managers to monitor the government’s
risk exposure and to take timely steps to control program costs.

Uncertainty in the estimation of insurance program costs must be
evaluated in terms of the direction and magnitude of the estimation errors.
For budgeting purposes, decisionmakers would be better served by
information that is more approximately correct on an accrual basis, than
they are by cash-based numbers that are exactly correct but misleading.
For example, industry analysts estimated that the accruing liabilities of
insolvent thrift institutions exceeded the resources of the insurance fund



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                             in the early 1980s, years before the full magnitude of losses began to be
                             recognized on a cash basis in the budget. Although estimates of the
                             growing cost of the savings and loan crisis were not exact, the magnitude
                             of the estimated losses proved to be correct. At the same time, the
                             President’s budget request for the insurance fund prior to its collapse in
                             1989 estimated that cash collections would exceed cash losses in all but
                             one year in the 1980s. Despite the uncertainty in the estimates of the
                             government’s accruing cost—the exact cost of the savings and loan crisis
                             is still not known with complete certainty—policymakers would have had
                             better budgetary information and incentives for decision-making if the
                             budget had reported such accrual-based estimates.

                             A key implementation challenge in adopting accrual-based budgeting for
                             insurance programs is the difficulty in producing risk-assumed cost
                             estimates. Although analogous to the implementation of credit reform, the
                             estimation challenges for some insurance programs may be greater than
                             those faced for most credit programs. For example, the cost of the
                             government’s deposit and pension insurance commitments is dependent
                             upon the ability to model complex interrelationships among highly
                             uncertain variables such as interest rates, market risks, and the solvency
                             of private companies. Estimation uncertainty will dictate continual
                             evaluation of the risk estimation methodologies used to generate
                             risk-assumed cost estimates for federal insurance programs.

                             For two programs in our study—Aviation War-Risk and Maritime War-Risk
                             insurance—the uncertainty in the risk-assumed cost estimates and other
                             implementation complexities probably outweigh the potential benefit from
                             an accrual-based budget treatment. Given the emergency or stand-by
                             nature of these programs, it is difficult to even know when they will be
                             activated. As a practical matter, the infrequent and sporadic issuance of
                             insurance, the resulting lack of historical experience, and the
                             extraordinary circumstances surrounding activation of the programs may
                             make the development of reliable risk-assumed estimates and the use of
                             accrual-based budgeting for these programs infeasible.


Accrual Budgeting Will       Earlier recognition of insurance program costs under an accrual-based
Increase the Complexity of   budgeting approach will add to the complexity of the budget treatment of
Budget Treatment             these programs compared with the current cash-based reporting.
                             Complexity is increased through the use of (1) sophisticated estimation
                             models, (2) multiple budget accounts and/or presentations, and
                             (3) procedures for reestimating costs reported as budget authority and/or



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                           outlays. Although recognition of insurance program costs may be
                           improved under an accrual-based budgeting approach, general
                           understanding of budget data and the budget process may decline. All of
                           this must be assessed in relation to the adequacy and often misleading
                           nature of cash budgeting for insurance programs.

                           As discussed in chapter 3, cash-based budgeting for insurance programs
                           generally does not provide adequate information for resource allocation
                           and fiscal policy decision-making. Although cash-based budgeting is
                           readily understandable to policymakers and the public, it generally does
                           not provide full information on insurance program costs at the time the
                           government’s commitment is extended and thus may impair resource
                           allocation and fiscal policy decision-making. Under credit reform, many
                           budget experts agree that despite the complexity of credit reporting,
                           decisions regarding a program’s structure—direct loans versus loan
                           guarantees versus grants—and funding have been improved. A similar
                           increase in complexity may be a necessary element to improving the
                           budget information on the cost of insurance programs. Discomfort with
                           and skepticism of these new measures could be alleviated by complete
                           documentation of the estimation and reestimation procedures.

                           The complexity of the budget treatment of credit programs was
                           significantly increased under the Federal Credit Reform Act of 1990. Very
                           few people really understand the details of budgeting and accounting for
                           credit programs. Although policymakers generally understand the concept
                           behind budgeting for credit programs—setting aside funds for future
                           losses—many still consider estimates of such costs as coming from a
                           “black box.” Such lack of understanding of the estimation and reporting
                           processes risks a loss of confidence in budget data. An accrual-based
                           approach to budgeting for federal insurance would entail many of the
                           same complexities, such as prospective cost estimation, multiple budget
                           accounts, and periodic reestimation of reported costs. To provide
                           confidence in the budget data, documentation and clear reporting are
                           crucial.


Approaches for             The three general approaches for incorporating accrual concepts into the
Incorporating Accrual      budget for insurance programs discussed in the previous chapter illustrate
Concepts Into the Budget   the fundamental trade-off between earlier cost recognition on the one
                           hand and increased uncertainty and complexity of budget reporting on the
Reflect Trade-Off          other. The degree of integration of accrual estimates in the
                           budget—whether in budget authority alone or also in outlays—will



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                 determine the impact of this information on decision-making. While
                 supplemental reporting of accrual-based costs would improve the
                 information available for resource allocation and fiscal policy decisions,
                 the actual impact on budget decisions is uncertain since the primary
                 budget data would be unaffected. However, integration of accrual
                 estimates into the budget beyond the supplemental approach also
                 increases the complexity of the budget treatment and the uncertainty in
                 the budget numbers.

                 The inherent uncertainty and complexity of accrual-based budgeting
                 approaches for insurance programs heightens the need for careful
                 consideration in the design and implementation of accrual-based
                 budgeting for these programs. Policymakers face a trade-off between the
                 need to improve information and incentives for decision-making and the
                 acceptable level of uncertainty and complexity in budget reporting. Some
                 budget experts believe that to have the most influence on budget
                 decisions, accrued costs should be recognized in budget authority and
                 outlays so that costs are reflected in the deficit. Others expressed concern
                 about increased complexity and the use of nonbudgetary financing
                 mechanisms such an approach would entail. This concern was heightened
                 by the uncertainty surrounding risk-assumed estimates for some insurance
                 programs. Further, some budget users stated that accrual-based
                 information is already available to policymakers—in supplemental budget
                 schedules and financial statements—and could be used in budget
                 decision-making without the added complexity of putting accrual
                 estimates into the budget numbers. The design and implementation of
                 accrual-based budgeting needs to address these concerns if the potential
                 benefits of accrual-based budgeting are to be achieved.


                 In implementing any of the three general approaches for accrual-based
Short-Term       budgeting for insurance programs, several short-term transitional issues
Implementation   would need to be addressed. First, as discussed in detail in chapter 5, the
Issues           current capacity to generate reliable risk-assumed estimates varies
                 considerably across insurance agencies. Difficulty in developing
                 risk-assumed cost estimates should be anticipated. Second, many agencies
                 expressed concern about the skills and resources necessary to implement
                 accrual-based budgeting and comply with new reporting requirements.
                 Experience gained in implementing an accrual-based budgeting approach
                 for credit programs could help guide the transition to accrual-based
                 budgeting for insurance programs. Supplemental reporting of
                 risk-assumed estimates would provide additional information for



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                           policymakers while providing time to evaluate a more comprehensive
                           approach.


Difficulty in Developing   Agency capacity to generate reasonably reliable risk-assumed cost
Risk-Assumed Cost          estimates for budget purposes varies considerably across programs.
Estimates Should Be        Indeed, the ability to generate reasonable cost estimates of the risk
                           assumed by the government was a primary concern expressed by the
Anticipated                insurance program agency officials and budget experts we spoke with. At
                           present, risk-assumed estimates of insurance losses related to coverage
                           extended in a budget year do not exist for all programs and are not
                           reported on a regular basis. Time and experience in developing these
                           estimates will be required. Credit agencies have had difficulties in
                           calculating reasonably accurate accrual cost estimates; similar and in
                           some cases greater difficulties can be anticipated for insurance programs.
                           However, experience also indicates that the focus placed on these
                           estimates in the budget has led to their improvement.

                           Agency capacity to generate risk-assumed cost estimates for insurance
                           programs will take time to develop. To implement accrual-based budgeting
                           for insurance programs would require refining and adapting the models
                           discussed in chapter 5. For example, an amortization process must still be
                           developed and tested to take the total estimated cost to the government of
                           pension insurance commitments generated by OMB’s model and convert it
                           to an annual basis for budgeting. Modifications that are likely to be
                           necessary to adapt the flood and crop insurance premium rate-setting
                           models for use in generating risk-assumed cost estimates for the budget
                           will also require time and resources. Agencies will require specialized
                           professional staff such as actuaries, economists, and statisticians to
                           develop and refine estimation models and produce the accrual cost
                           estimates on a regular basis. Some agency officials we spoke with
                           expressed concern about their ability to generate such estimates given
                           current staff resources.

                           In implementing credit reform, we found that agencies experienced
                           difficulty accurately estimating accrual-based cost estimates for three
                           principle reasons: (1) future economic conditions are uncertain, (2) the
                           government often is the lender of last resort, making it difficult to judge
                           the risk, and (3) agencies’ historical data were nonexistent or unreliable.1
                           These same factors will complicate estimating risk-assumed cost estimates

                           1
                           For additional information see Federal Credit Programs: Agencies Had Serious Problems Meeting
                           Credit Reform Accounting Requirements (GAO/AFMD-93-17, January 6, 1993).



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for insurance programs. In addition, differences between insurance
commitments and loan guarantees will add to the complexity of generating
accrual cost estimates for insurance programs. Unlike most credit
programs which are limited by discretionary appropriations, the majority
of insurance programs are mandatory and thus are not limited to a specific
amount of insurance. Estimation is therefore complicated by the need to
forecast demand for insurance—for example, the number of farmers
opting for crop insurance coverage or the amount of deposits flowing into
banks as opposed to other investment opportunities.

Improvements in the estimation of the government’s cost of insurance
extended can be expected if accrual-based budgeting is adopted for these
programs. Advocates of accrual-based budgeting point to the credit reform
experience and argue that requiring estimates of the full cost of insurance
programs in the budget would provide the incentive necessary to improve
the quality of the estimates. For example, in response to credit reform
reporting requirements, the Small Business Administration (SBA), in
conjunction with OMB, recently completed an extensive analysis of its loan
records dating back to fiscal year 1983. Prior to this study, SBA had been
unable to validate its subsidy estimates or provide reestimates as required
by credit reform. As a part of this analysis, SBA developed a model which
allows it to take into account various loan and borrower characteristics in
its subsidy estimates. Refined estimates of historical default and recovery
rates were used to generate fiscal year 1997 budget estimates and
reestimate prior year subsidy estimates.

The accuracy and reliability of estimates will also improve as a result of
refinements in methodologies and the collection of additional data on
program experience. For example, OMB has made several refinements to its
deposit insurance model since it first applied options pricing theory to
estimate the accruing costs of the program in 1990. The availability of data
necessary for estimating accrual costs for some programs should improve
over time, which in turn should improve the reliability of the risk-assumed
cost estimates. For example, in its model for estimating costs of thrift
deposit insurance, OMB has used data from small commercial banks to
estimate various parameters. Although significant differences exist
between bank and thrift institutions, the data OMB needed for its model do
not exist for thrifts before 1990. Data available since 1990 are biased due
to the recovery of the thrift industry during this period after the savings
and loan crisis. As thrift data encompassing periods of both economic
growth and contraction become available, OMB will be able to incorporate
them into its thrift deposit insurance model. Similarly, risk assessment for



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                           the National Vaccine Injury Compensation program has been hampered by
                           the relatively short existence of the program. Claims from 1989, the
                           program’s first year of operation, have not all been settled. The reliability
                           of estimates of the program’s potential costs will be difficult to judge until
                           data from at least several years of program operation are available.


Agencies Raised Concerns   Agencies expressed concern about the staff and system resources
About Their Ability to     necessary to implement an accrual-based budgeting approach similar to
Implement Accrual-Based    the outlay approach described in the previous chapter. They stated that
                           additional resources would likely be necessary to generate cost estimates,
Budgeting                  collect the necessary data, and comply with new reporting requirements.
                           Some agencies question whether the benefits of this type of an approach
                           would be worth the resources required. Smaller agencies expressed
                           concern that new requirements under an accrual system could divert
                           resources from program operations and management. For example, the
                           National Vaccine Injury Compensation program is administered by a staff
                           of 25, 12 of whom are medical examiners. According to the agency, an
                           increase in resources would be necessary to develop risk-assumed
                           estimates for the budget.

                           As with credit reform, agencies would be faced with significant
                           implementation challenges. While the characteristics of insurance
                           programs may add additional complexity, experience gained from
                           implementing credit reform could mitigate some of the agencies’ concerns.
                           Some agencies that administer insurance programs also administer credit
                           programs. Officials and staff at these agencies expressed strong concerns
                           about the expanded reporting and data requirements of accrual-based
                           budgeting, which were required under credit reform. For example,
                           officials at the Veterans Benefits Administration (VBA), which oversees
                           veterans’ life insurance programs as well as several loan guaranty
                           programs, were generally supportive of an accrual-based budgeting
                           approach for insurance. However, they stated that they would not be
                           supportive of an accrual-based approach modeled after the treatment of
                           loan guarantees under credit reform. They said that they did not believe
                           that the outcome would be worth the cost needed to achieve it. In
                           particular, they cited greatly expanded reporting requirements for VBA’s
                           loan guaranty programs that required a large increase in resources needed
                           to prepare the budget and track all the necessary data. Officials and staff
                           of the Overseas Private Investment Corporation expressed similarly strong
                           concerns. These concerns were based on their experience implementing
                           credit reform for OPIC’s loan and loan guarantee programs.



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Some agency officials suggested that accrual-based information is already
available in the budget. Officials at OPIC expressed the opinion that the
agency uses accrual-based estimates in the budget to the extent
appropriate. OPIC currently obligates funds as a general reserve for the risk
inherent in its insurance activities in the period it is estimated. OPIC
officials stressed that the tools necessary to recognize insurance program
costs already exist within the current budget process. Improved
recognition of insurance program costs could be achieved by requiring
agencies to obligate budget authority as a reserve when costs are
estimated. This is essentially the aggregate budget authority approach
outlined in the previous chapter. OPIC officials said that such an approach
would improve cost recognition for federal insurance programs without
adding to the complexity and burden of a system similar to credit reform.
Officials of the Office of Personnel Management Retirement and Insurance
Service also stated that currently, information on the assets and accrued
liabilities of the Federal Employees’ Group Life Insurance fund is provided
as part of the budget presentation. They said that they would be
uncomfortable using accrual concepts more extensively in the budget due
to the many factors involved in estimation and the uncertainty of such
estimates.

Lessons learned from the implementation of credit reform could help
address agency concerns about accrual-based budgeting for federal
insurance programs. In the 5 years since credit budgeting and accounting
reforms were implemented, OMB and the Department of the Treasury have
been working with credit agencies to simplify requirements. Several
interagency working groups have been formed to identify ways to comply
with credit reform at the lowest possible cost, improve and standardize
audit requirements, and utilize credit reform data and concepts for internal
management purposes.2 Recommendations to streamline a number of data
reporting and reestimation requirements have been partially implemented.
The experience and recommendations of these work groups could aid in
the development of rational procedures and reporting requirements for an
accrual-based budgeting approach for insurance programs.




2
These groups include the Federal Credit Policy Working Group, Credit Reform Committee of the
Chief Financial Officers Council, and a GAO, OMB, and Treasury task force on auditing guidance.



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Supplemental Reporting of       The potential for accrual-based budgeting based on estimates of the risk
Risk-Assumed Estimates          assumed by the government to improve budget information and incentives
Would Allow Time to             for federal insurance programs argues for its implementation. However,
                                the need to build capacity to generate risk-assumed cost estimates and the
Evaluate a More                 complexity of the implementation issues involved indicate that it is not
Comprehensive                   feasible at this time to integrate risk-assumed cost estimates directly into
Accrual-Based Budgeting         the budget. Since risk-assumed estimates have not been produced and
Approach                        reported on a regular basis for most insurance programs, supplemental
                                reporting of these estimates over a number of years could help
                                policymakers understand the extent and nature of the estimation
                                uncertainty and allow time to evaluate the feasibility of adopting a more
                                comprehensive accrual-based budgeting approach.

                                If evaluation of the risk-assumed estimates demonstrates that estimation
                                has developed sufficiently so that use of risk-assumed data in the budget
                                will not introduce an unacceptable level of uncertainty, policymakers
                                could consider a second phase of implementation—incorporating
                                risk-assumed estimates into budget authority. The final phase would be
                                the use of risk-assumed estimates in budget authority, outlays, and the
                                deficit.

                                Supplemental reporting of risk-assumed cost estimates in the budget
                                would allow time to:

                            •   develop and refine estimation methodologies,
                            •   assess the reliability of risk-assumed estimates,
                            •   gain experience and confidence in cost measures for budget purposes,
                            •   evaluate the feasibility of a more comprehensive accrual-based budgeting
                                approach, and
                            •   formulate cost-effective reporting procedures and requirements.

                                During this period, policymakers should continue to draw on information
                                provided in audited financial statements. As noted in the report, financial
                                statements can provide earlier recognition of accruing liabilities than does
                                the cash-based budget for insurance commitments.

                                The Government Performance and Results Act (GPRA) of 1993, which laid
                                out a series of steps to better integrate performance measures into the
                                budget, could be used as a model for incorporating accrual cost measures
                                in the budget. Statutorily-required evaluation of risk-assumed estimates
                                would focus attention on improving cost estimation and provide an
                                opportunity to assess the practicality of incorporating such estimates



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directly into budget authority, outlays, and the deficit. In the case of credit
programs, estimates of interest rate subsidies were reported in the budget
for 20 years prior to the implementation of accrual-based budgeting for
those programs. The current capacity to generate risk-assumed estimates
for insurance programs suggests that the additional focus and time
allowed under a phased-in approach is warranted. Experience gained from
this period would also be helpful in evaluating whether additional control
mechanisms, such as discretionary funding of subsidies, are needed or
desirable.

An alternate strategy would be to implement accrual-based budgeting on a
program-by-program basis with consistent treatment of all insurance
programs as the ultimate goal. Programs which have well-developed or
established estimation methodologies would immediately be switched to
an aggregate outlay accrual approach. Programs for which estimation
methodologies do not exist or are not widely accepted would be required
to develop or refine models. This would allow for the benefits of
accrual-based budgeting to be realized immediately for some programs
while other programs develop the necessary estimation methodologies
and expertise.

Such a program-by-program approach has several drawbacks. First, it
would introduce a lack of comparability among insurance programs in the
budget—perhaps even skewing their apparent relative costs—and increase
confusion about the information provided on insurance program costs.
Second, a program-by-program approach fails to establish a standard for
new insurance programs. Without such a standard, the long-term expected
cost of any new insurance program may not be fully considered when the
decision is made to establish it since only the program’s initial years’ cash
flows would be reported in the budget. Finally, programs for which
accrual-based budgeting holds the greatest benefits, such as deposit
insurance and pension guarantees, are the ones for which implementation
will be most difficult. Focusing time and resources on implementing
accrual-based budgeting where the potential benefits are greatest offers
the greatest potential for improved information. Implementing
accrual-based budgeting for those programs where the benefits are low
but not for other programs may lead to a situation in which efforts exceed
the benefits and this could make it more difficult to sustain the effort
necessary to proceed where potential benefits are greatest.




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                        The design and structure of an accrual-based budgeting approach for
Technical Design        insurance programs will be a critical factor in its acceptance and
Issues                  effectiveness. Although accrual-based budgeting for these programs has
                        the potential to improve budget information and incentives, individual
                        program characteristics, differences in the government’s commitment, and
                        the ability to generate reasonably reliable accrual cost estimates will
                        require considerable effort in the design of processes and reporting
                        requirements. The increased uncertainty and complexity involved in
                        incorporating accrual measures into the budget heightens the need for
                        careful consideration of technical design issues before moving to a more
                        comprehensive accrual-based budgeting approach. These issues include
                        the treatment of loss reserves, reestimation and funding shortfalls,
                        previously accumulated program deficits, and administrative costs.


Establishing and        Under a risk-assumed accrual-based budgeting approach for insurance
Maintaining Insurance   programs, premium income in some years will exceed claim payments,
Reserves                while in other years income will be lower than claims. Because the insured
                        risks cannot be diversified or pooled over a large enough number of
                        participants with different potential for losses, reserves cannot be tied to
                        commitments made in a given year. Instead, a general reserve would be
                        established based on the risk inherent in the type of insurance provided.
                        This would be a major difference between reserves for insurance
                        programs and credit programs. In general, for credit programs, the large
                        volume of loans or guarantees issued in any single year allows for
                        sufficient diversification of risk and permits reserves to be set aside for
                        each annual “book of business.” These reserves are reestimated annually
                        over the life of each book of business.

                        Establishment of program reserves sufficient to cover the long-term cost
                        of the insurance extended will take time and involve significant program
                        funds. If premium rates were set to cover the long-term expected cost of
                        the insurance extended, sufficient reserves could be established over time.
                        However, until such reserve levels are reached, appropriations or
                        borrowing authority may be necessary to cover claims in high loss years.
                        Assuming that the program’s risk is adequately estimated, premium
                        income would be sufficient in the long-term to repay any borrowing or
                        appropriation and build reserves.

                        Maintaining funds set aside for insurance program reserves was a concern
                        raised by several budget professionals. Because insurance reserves must
                        be accumulated over several years and since the reserves are not tied to



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                           Chapter 7
                           Implementing Accrual Budgeting for Federal
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                           any specific year’s insurance commitments, funds could potentially be
                           diverted to fund other program priorities, particularly given current budget
                           constraints. This may be more of an issue under the budget authority
                           approach than the outlay approach described in the previous chapter.
                           Reserves held in nonbudgetary financing accounts under credit reform
                           have thus far been maintained for their intended purpose. On the other
                           hand, officials at the Federal Emergency Management Agency (FEMA)
                           stated that when the flood insurance program began to accumulate
                           reserves in the late 1980s, the Congress used the surplus to fund flood
                           studies, flood plain management, and program salaries.


Reestimation and Funding   Periodic reestimation of the expected cost of the government’s insurance
Shortfalls                 commitments will be necessary. Upward reestimates of the cost of the risk
                           insured should be reflected in premium rates for new insurance
                           commitments and/or the government’s subsidy. More complicated will be
                           the funding of increases in the estimated costs of outstanding insurance
                           commitments. Under credit reform, agencies are given permanent,
                           indefinite authority to cover upward reestimates of the government’s costs
                           related to credit commitments made in prior years. The architects of credit
                           reform contend that this authority is necessary to encourage unbiased cost
                           estimates and because some factors that affect costs—such as the
                           economy—are beyond an agency’s control. Agencies are required to
                           incorporate the factors that prompted a reestimation into the estimates of
                           future subsidy costs. Conversely, some budget experts contend that the
                           provision of permanent authority has created the potential for bias in
                           original estimates since funding for any additional cost is provided
                           automatically outside the appropriation process.

                           The nature of the government’s insurance commitment and the sensitivity
                           of the largest insurance programs—deposit and pension insurance—to
                           fluctuations in interest rates and general business conditions may make
                           limiting the costs of reestimates and funding shortfalls difficult. Most
                           federal insurance programs are open-ended, providing as much insurance
                           as demanded. Unlike most federal credit programs in which the number of
                           loans or loan guarantees can be specified and funding provided, it is
                           neither practical nor desirable to directly limit insurance coverage—for
                           example, by limiting the number of children vaccinated or the vesting of
                           pension benefits. Thus, in changing the budget treatment of these
                           programs, consideration must be given to the impact changes may have on
                           the programs’ operations.




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                         The Bush administration’s 1992 accrual budgeting proposal would have
                         required the Congress to provide a mandatory appropriation when an
                         insurance program’s costs exceeded its available resources on an accrual
                         basis. The administration argued that, given the nature of the insurance
                         commitments and their current budget treatment, this would have only
                         explicitly authorized what was implicit under existing law. Other methods
                         of handling shortfalls in a program’s funding could be considered. For
                         example, a funding shortfall could trigger a premium increase unless the
                         Congress acted to implement program reforms aimed at reducing program
                         costs. Alternatively, premium increases or program coverage reductions
                         could be implemented if reserves fell below certain specified levels. The
                         impact on program participants could be mitigated by spreading the
                         premium increase over several years.

                         Additional control mechanisms must be carefully designed or they could
                         risk increasing overall costs to the government due to program
                         interactions. For example, if a funding shortfall were to develop in the
                         flood insurance program leading to a premium increase, this could cause
                         participation in the program to fall. Ultimately, diminished participation
                         could potentially lead to increased future costs to the government in the
                         form of disaster relief.


Previously Accumulated   Some federal insurance programs that provide coverage for an extended
Program Deficits         or indefinite period of time, such as the Federal Employees’ Group Life
                         Insurance program, currently report program deficits as measured under
                         traditional accounting standards. The deficit for FEGLI at the end of 1996
                         was $3.4 billion. How costs incurred prior to conversion to accrual-based
                         budgeting should be treated would have to be determined.

                         Several options exist for the reporting and funding of these costs. If
                         estimates of the accrued costs at conversion can be made, under an
                         accrual outlay approach these costs could be reported as a separate line in
                         the program account. If the information necessary to estimate the future
                         cash flows resulting from the previously accrued costs is unavailable or if
                         the population insured changes significantly from year to year, a separate
                         liquidating account could be used. If a liquidating account is used, funding
                         of accrued costs could remain on a cash basis and simply be paid as claims
                         come due. Alternatively, accumulated deficits could be amortized over a
                         reasonable period of time and funded through appropriations or premium
                         increases. These funds would be outlayed to the financing account and
                         paid out for claims as necessary.



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Administrative Costs   The treatment of insurance programs’ administrative costs will need to
                       take into account the intended financing of such expenses. Currently,
                       most programs fund administrative costs out of premium income, although
                       some receive appropriated funds to cover these expenses. If a program is
                       intended to be self-supporting, then an amount to cover administrative
                       costs should be included in the risk-based premiums charged to
                       participants. Under an accrual outlay approach, premium income would
                       flow into the financing account and an amount would be transferred to the
                       program account to cover administrative costs. The reported cost to the
                       government would be zero. If a program is not self-supporting, an
                       appropriation to the program account to cover administrative costs would
                       be required. Administrative costs would be charged to the program
                       account along with any premium subsidy. Outlays from this account would
                       equal the total cost to the government for the insurance extended.




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Chapter 8

Conclusions, Recommendation, and Agency
Comments

             To support current and future resource allocation decisions and be useful
             in the formulation of fiscal policy, the federal budget needs to be a
             forward-looking document that enables and encourages users to consider
             the future consequences of current decisions. As such, the budget should
             clearly reflect the financial consequences of decisions made and provide
             the information and incentives necessary to assess the future implications
             of these choices. The current cash-based budget, however, generally
             provides incomplete and misleading information on the cost and fiscal
             impact of federal insurance programs. The use of accrual concepts in the
             budget for these programs has the potential to better inform budget
             choices. However, technical and practical challenges exist which will
             require careful and deliberate consideration in the design and
             implementation of an accrual-based budgeting approach for insurance
             programs.

             Cash-based budgeting for federal insurance programs is limited for
             resource allocation and fiscal policy decisions because its focus on
             single-period cash flows does not usually reflect the government’s cost at
             the time the decisions are made to provide insurance coverage. The
             cash-based budget may misstate the cost of the government’s insurance
             commitments in any particular year because the time between receipt of
             program collections, the occurrence of an insured event, and the final
             payment of a claim can extend over several budget periods. As a result,
             current and future resource allocations may be distorted. Cash budgeting
             also is generally not an accurate gauge of the economic impact of federal
             insurance. While these shortcomings of cash-based budgeting exist for all
             insurance programs, the degree to which cash-based information is
             misleading varies significantly across programs.

             The use of accrual-based budgeting for federal insurance programs has the
             potential to overcome a number of the deficiencies of cash-based
             budgeting. Accrual-based reporting would recognize the cost of the
             insurance commitment when the decision is made to provide the
             insurance, regardless of when cash flows occur. This earlier recognition of
             the cost of the government’s commitment would (1) allow for more
             accurate cost comparisons with other programs, (2) provide an
             opportunity to control costs before the government is committed to
             making payments, (3) build budget reserves for future claims, and
             (4) better capture the timing and magnitude of the impact of the
             government’s actions on private economic behavior. The degree to which
             accrual-based measures would improve cost recognition in the budget for
             insurance programs will vary based on the size and length of the



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government’s commitment, the nature of the insured risks, and the extent
to which costs are currently captured in the budget. Further, whatever the
conceptual benefits of risk-assumed cost measurement, the effective
implementation of accrual-based budgeting on this basis is dependent on
the ability to generate reasonable unbiased estimates of these costs.

In the past, concerns over the limitations of cash-based budgeting and the
benefits of a shift to accrual-based budgeting have been driven by the
financial condition of the two largest programs—deposit and pension
insurance. These two programs remain central to the argument for
accrual-based budgeting for insurance programs. The size of these
programs in relation to total federal spending, and therefore their potential
to distort resource allocation and fiscal policy, make the limitations of
cash-based budgeting and the benefits of accrual-based budgeting more
pronounced. The case for using accrual-based budgeting for other federal
insurance programs varies in strength. Their smaller size and the degree to
which cost information is currently considered by policymakers reduce to
a varying degree the extent to which information and incentives would be
improved under an accrual-based budgeting approach.

The ability to generate reasonable, unbiased estimates of the risk assumed
by the government is critical to the successful implementation of
accrual-based budgeting for insurance programs. As described in this
report, the development and acceptance of estimation methodologies
varies considerably across programs. The characteristics of the risks
insured by the federal government, frequent program modifications, and
the absence of sufficient data on possible losses have hampered the
development of risk-assumed estimates. The use of risk-assumed
estimates in the budget will require the refinement and adaptation of
existing models and, in some cases, the development of new
methodologies. Because risk-assumed estimates for the various insurance
programs have not been produced and reported on a regular basis, it
should be expected that agencies will need time to develop the capacity to
generate these estimates for the budget. During this time period, the
information on insurance losses contained in the programs’ financial
statements, which are included in the budget appendix, provide
policymakers with a valuable resource in monitoring these programs.

Improvements in estimation methodologies, available data, and
assumption specifications may, over time, lead to more accurate cost
estimates, but because insurance program costs are dependent upon many
variables, some uncertainty in the reported accrual estimates is



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Comments




unavoidable. The use of sophisticated estimation models, new budget
presentations, and the need for periodic reestimates will add complexity
to the budget process. As a result, understanding of budget data and the
budget process may decline. However, this increased complexity should
be assessed in relation to the adequacy of cash-based budgeting for
insurance programs. Although cash-based budgeting is readily
understandable to policymakers and the public, it generally provides
incomplete or misleading information on insurance program costs and
thus may impair resource allocation and fiscal policy decision-making.

We believe that the potential benefits of an accrual-based budgeting
approach for federal insurance programs warrant continued effort in the
development of risk-assumed cost estimates. The complexity of the issues
involved and the need to build agency capacity to generate risk-assumed
cost estimates suggest that it is not feasible to integrate accrual-based
costs directly into the budget at this time. Supplemental reporting of these
estimates in the budget over a number of years could help policymakers
understand the extent and nature of the estimation uncertainty and permit
an evaluation of the desirability and feasibility of adopting a more
comprehensive accrual-based approach. The value of reporting
risk-assumed estimates was also endorsed by FASAB in accounting
standards it developed, which require disclosure of risk-assumed cost
estimates as supplemental information for insurance programs beginning
with financial statements for fiscal year 1997. However, the Board also
recognized the difficulty of preparing reliable risk-assumed estimates and,
therefore, did not require their recognition on the financial statements as a
liability.

Supplemental reporting of risk-assumed cost estimates in the budget has
several attractive features. It would allow time to (1) develop and refine
estimation methodologies, (2) assess the reliability of risk-assumed
estimates, (3) formulate cost-effective reporting procedures and
requirements, (4) evaluate the feasibility of a more comprehensive
accrual-based budgeting approach, and (5) gain experience and
confidence in risk-assumed estimates. At the same time, the Congress and
the executive branch will have had several years of experience with credit
reform, which can help inform their efforts to apply accrual-based
budgeting to insurance. During this period, policymakers should continue
to draw on information provided in audited financial statements.

If risk-assumed estimates develop sufficiently so that their use in the
budget will not introduce an unacceptable level of uncertainty,



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                 Conclusions, Recommendation, and Agency
                 Comments




                 policymakers could consider incorporating risk-assumed estimates
                 directly into the budget. While supplemental reporting of risk-assumed
                 estimates would improve the information on the cost of insurance
                 commitments, the actual impact on budget decisions is uncertain since the
                 primary budget data—budget authority and outlays—would be unaffected.
                 Directly incorporating accrual-based cost estimates in both budget
                 authority and outlays would have the greatest impact on the incentives
                 provided to decisionmakers but would also significantly increase reporting
                 complexity and introduce new uncertainty in reported budget data.
                 Between these two approaches is one of incorporating accrual-based costs
                 in budget authority alone, which has fewer of the disadvantages of the full
                 accrual approach but also less impact on decision-making incentives. If an
                 action-causing budget mechanism is desired, requiring a discretionary
                 appropriation for the accrual-based cost of the government’s subsidy
                 could provide additional incentive to control the government’s cost
                 but—by changing the locus of decisions to the annual appropriation
                 process—would go beyond merely changing the reporting of program
                 costs and change the nature of federal insurance.


                 The Congress may wish to consider encouraging the development and
Matter for       subsequent reporting of annual risk-assumed cost estimates in conjunction
Congressional    with the cash-based estimates for all federal insurance programs in the
Consideration    President’s budget. The Congress may also wish to consider periodically
                 overseeing and assessing the reliability and usefulness of these estimates,
                 making adjustments, and determining whether to move toward a more
                 comprehensive accrual-based budgeting approach for insurance programs.


                 We recommend that the Director of the Office of Management and Budget
Recommendation   develop risk-assumed cost estimation methods for federal insurance
                 programs and encourage similar efforts at agencies with insurance
                 programs. As they become available, the risk-assumed estimates should be
                 reported annually in a standardized format for all insurance programs as
                 supplemental information along with the cash-based estimates. A
                 description of the estimation methodologies used and significant
                 assumptions made should be provided. To promote confidence in
                 risk-assumed cost measures, the estimation models and data should be
                 available to all parties involved in making budget estimates and should be
                 subject to periodic external review. As data become available, OMB should
                 undertake and report on evaluations of the validity and reliability of the
                 reported estimates.



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                     Conclusions, Recommendation, and Agency
                     Comments




                     Officials from OMB agreed with this report’s conclusion that budgeting for
Agency Comments      insurance programs should be based on the government’s long-term
and Our Evaluation   expected cost of the insurance extended—the risk assumed by the
                     government. Furthermore, OMB agreed that the challenges involved in
                     bringing risk-assumed estimates into the budget are significant and that
                     additional effort to improve estimation methods is required. OMB officials
                     noted that they would like to pursue such improvements but are not doing
                     so because they do not currently have the expertise that would be
                     required.

                     OMB  officials expressed concern about GAO’s use of the terms “cash” and
                     “accrual” in this report to describe different approaches to budgeting for
                     insurance programs. GAO chose to use the term “cash-based” because cash
                     is the measurement basis for the amounts shown in the budget for budget
                     authority, obligations, outlays, and receipts. The estimates for these
                     amounts generally are made in terms of cash payments to be made or
                     received. Under current budget concepts, these amounts reflect the cash
                     flows associated with the insurance program activities—paying claims for
                     events that have already occurred and collecting premiums for new
                     commitments. GAO uses the term “accrual-based” to describe the use of
                     risk-assumed cost estimates as the basis for reporting an insurance
                     program’s budget authority, obligations, and outlays. Although, as OMB
                     noted and discussed in chapter 4 of this report, the term “accrual” can be
                     applied to a range of concepts and measures, GAO uses the term in the
                     report because it is generally understood as a basis of measuring cost
                     rather than cash flows.

                     OMB officials also suggested that the current federal budget system can be
                     thought of as commitment-based or obligation-based budgeting and that
                     the use of risk-assumed cost estimates is consistent with this concept. GAO
                     agrees that this is a useful way of thinking about the potential changes in
                     budgeting for insurance programs described in this report. As discussed in
                     the report, using accrual-based cost information rather than cash-based
                     information for reporting budget authority, obligations, and outlays could
                     improve the recognition of the cost of the government’s commitments at
                     the time it makes them. OMB officials made this same point saying that
                     “cash does not carry out the principle of recognizing the cost of
                     commitments at the time they are made.”

                     GAO modified relevant sections of the report to clarify its explanation of
                     OMB’sviews on the budget treatment of deposit insurance under an
                     accrual-based approach. According to OMB officials, it was not OMB’s intent



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Conclusions, Recommendation, and Agency
Comments




to treat deposit insurance differently from other insurance programs under
the Bush administration’s 1992 insurance budgeting proposal. OMB agrees
with GAO that for all programs what should be measured is the long-term
expected cost of loss-generating events less premiums collected. However,
given the nature and complexity of deposit insurance, the extent to which
the OMB model—or any model—would be able to capture the full long-term
expected cost of the government’s commitments is open to debate. This is
due, in part, as OMB acknowledges, to the very difficult conceptual and
measurement problems associated with accounting for rare catastrophic
events, such as the savings and loan crisis, in a risk-assessment model.

Based on OMB officials’ suggestions, GAO dropped from chapter 1 a brief
discussion of early budget commissions’ recommendations regarding
accrual accounting in the federal government which was not necessary to
convey our message that the current system of budgeting for insurance
programs is deficient and may be improved with the use of risk-assumed
measures.

OMB officials also provided a number of technical comments, which were
incorporated into the report as appropriate.




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Page 149   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Appendix I

Budget Account Structure and Reporting
Flows for Credit Programs

              The Credit Reform Act set up a special budget accounting system to
              record the budget information necessary to implement credit reform. It
              provides for three types of accounts—program, financing, and
              liquidating—to handle credit transactions.

              Credit obligations and commitments made on or after October 1,
              1991—the effective date of credit reform—use only the program and
              financing accounts. The program account receives separate appropriations
              for the administrative and subsidy costs of a credit activity and is included
              in budget totals. When a direct or guaranteed loan is disbursed, the
              program account pays the associated subsidy cost for that loan to the
              financing account. The financing account, which is nonbudgetary,1 is used
              to record the cash flows associated with direct loans or loan guarantees
              over their lives. It finances loan disbursements and the payments for loan
              guarantee defaults with (1) the subsidy cost payment from the program
              account, (2) borrowing from the Department of the Treasury, and
              (3) collections received by the government. If subsidy cost calculations are
              accurate, the financing account will break even over time as it uses its
              collections to repay its Treasury borrowing. Figure I.1 diagrams this cash
              flow.




              1
               Nonbudgetary accounts may appear in the budget document for information purposes but are not
              included in the budget totals for budget authority or outlays. They do not belong in the budget because
              they show only how something is financed and do not represent the use of resources.



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                                       Appendix I
                                       Budget Account Structure and Reporting
                                       Flows for Credit Programs




Figure I.1: Simplified Credit Reform
Cash Flow                                          Appropriations                                             Treasury


                                           Administrative cost                                           Borrowing

                                                                 Subsidy cost                                         Repayments




                                                                                    Subsidy cost
                                                        Program                                                 Financing
                                                        Account                                                  Account




                                           Administrative cost                         Payments for          Loan               Collections (fees,
                                                                                       loan guarantees       disbursements      principal/interest,
                                                                                                                                recoveries from
                                                                                                                                defaults)




                                       Direct loans and loan guarantees made before October 1, 1991, are
                                       reported on a cash basis in the liquidating account. This account continues
                                       the cash budgetary treatment used before credit reform and has
                                       permanent, indefinite budget authority2 to cover any losses. Excess
                                       balances are transferred periodically—at least annually—to the Treasury.

                                       In addition to the three accounts specified in the Credit Reform Act, OMB
                                       has directed that credit programs or activities with negative subsidies
                                       must have special fund receipt accounts to hold receipts generated when
                                       the program or activity shows a profit.




                                       2
                                        Permanent budget authority is available as a result of permanent legislation and does not require
                                       annual appropriation. Indefinite budget authority is budget authority of an unspecified amount of
                                       money.



                                       Page 151                                 GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Appendix II

Deposit Insurance


              Federal deposit insurance was initiated in the 1930s to help restore
Purpose       confidence in the nation’s banking system after thousands of financial
              institutions failed and millions of dollars in deposits were lost during the
              Great Depression. The Banking Act of 1933 established the Federal
              Deposit Insurance Corporation (FDIC) to provide protection for bank
              depositors and to foster sound banking practices. A year later, the Housing
              Act of 1934 extended federal deposit insurance to thrift institutions.
              Federal insurance for credit unions was established in 1970. Federally
              insured deposits are explicitly backed by the full faith and credit of the
              U.S. government.

              Federal deposit insurance is administered by two federal agencies—FDIC
              and the National Credit Union Administration (NCUA). Pursuant to the
              Financial Institutions Reform, Recovery, and Enforcement Act of 1989
              (FIRREA), FDIC oversees both the Bank Insurance Fund (BIF), which insures
              deposits at commercial banks and some savings banks,1 and the Savings
              Association Insurance Fund (SAIF), which insures deposits at savings and
              loan institutions and savings banks not covered by BIF.2 The Deposit
              Insurance Funds Act of 1996 (Title II, Subtitle G of Public Law
              104-208) makes provisions for the merger of BIF and SAIF into a single
              deposit insurance fund effective January 1, 1999, provided that the
              Congress enacts legislation to merge the bank and thrift charters and to
              eliminate differences in powers and ownership structures between banks
              and savings associations. NCUA administers the Credit Union Share
              Insurance Fund (CUSIF), which insures credit union accounts.




              1
               State-chartered mutual savings banks—those owned by depositors rather than shareholders—were
              included among the institutions eligible for deposit insurance from FDIC when it was established in
              1933. In recent years, many of these savings banks have converted from mutual ownership to stock
              ownership and are simply referred to as savings banks. Historically, these savings banks have operated
              like savings and loan institutions in that they channelled savings from individuals to make residential
              mortgages, but have had broader lending and investment powers than savings and loans.
              2
               Prior to August 9, 1989, federal deposit insurance for thrift institutions was provided through the
              Federal Savings and Loan Insurance Corporation (FSLIC). FIRREA abolished FSLIC and transferred its
              assets, liabilities, and contracts to a newly created FSLIC Resolution Fund and established SAIF as the
              new thrift insurance fund. FDIC was designated the administrator of both funds. In addition, FIRREA
              created the Resolution Trust Corporation to resolve all troubled institutions placed into
              conservatorship or receivership from January 1, 1989, through August 8, 1992. This period was later
              extended to June 30, 1995.



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                           Deposit Insurance




                           Budget Accounts: Bank Insurance Fund (BIF)
Bank and Thrift                             (51-4064-0-3-373)
Deposit Insurance                           Savings Association Insurance Fund (SAIF)
                                            (51-4066-0-3-373)

                           Agency: Federal Deposit Insurance Corporation (FDIC)


Coverage                   Domestic deposits in commercial banks, savings banks, savings
                           associations, and other thrift institutions are insured up to $100,000 per
                           account. The insured amount has been raised six times since 1934 with the
                           current limit of $100,000 set by the Depository Institutions Deregulation
                           and Monetary Control Act of 1980. At the end of 1995, over $1.9 trillion in
                           deposits at approximately 10,000 commercial banks and savings banks
                           were insured by BIF, while SAIF insured more than $700 billion in deposits
                           at approximately 1,700 thrift institutions.


Eligibility Requirements   Banks and savings institutions can only conduct business if they obtain a
                           charter (license to operate) from either the federal or state government.
                           The laws and regulations underlying charters specify the activities in
                           which institutions may engage and the supervisory requirements they must
                           meet. Federal charters are granted by two offices within the Department
                           of the Treasury. The Office of the Comptroller of the Currency (OCC) is
                           responsible for chartering federal (national) banks and the Office of Thrift
                           Supervision (OTS) approves charters for federal savings associations.

                           In evaluating an application to organize a new bank, OCC considers the
                           institution’s earning prospects, the adequacy of its capital, its anticipated
                           community services, the ability of its management, and the safety and
                           soundness of intended operations. In issuing charters to operate thrift
                           institutions, OTS is required to give primary consideration to the best
                           practices of thrift institutions in the United States, which generally means
                           the same factors applied by OCC for banks. Chartering requirements for
                           state banks and savings associations vary by state. However, most if not all
                           states now require that new banks and thrifts obtain federal deposit
                           insurance, which effectively provides FDIC with veto power over the
                           granting of state charters.

                           In extending deposit insurance, FDIC is required by law to consider (1) the
                           financial history and condition of the depository institution, (2) the
                           adequacy of its capital, (3) the future earnings prospects of the institution,



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                    (4) the general character and fitness of its management, (5) the risk
                    presented by the institution to the insurance fund, (6) the needs of the
                    community to be served, and (7) whether the institution’s corporate
                    powers are consistent with the purposes of the Federal Deposit Insurance
                    Act. Successful applicants for national charters qualify immediately for
                    federal deposit insurance.

                    All federally insured banks and thrifts are subject to federal supervision
                    and examination whether they are state or federally chartered. Federal
                    oversight is split among four regulatory agencies based on the type of
                    institution. OCC supervises all national banks. OTS serves as the primary
                    regulator for thrift institutions and thrift holding companies. The Federal
                    Reserve Board has oversight authority for state-chartered banks that are
                    members of the Federal Reserve System (FRS) and bank holding
                    companies. FDIC is the primary federal regulator of state-chartered banks
                    that are not members of FRS. By law, federal regulators are required to
                    conduct annual on-site examinations of all federally insured institutions
                    except for certain well-managed and financially strong institutions with
                    assets of less than $250 million, which must be examined every 18 months.


Program Financing   Federal deposit insurance for banks and thrift institutions is financed from
                    annual premium assessments. Other sources of funds include interest
                    earned on investments in U.S. Treasury obligations, income from the
                    management and disposition of assets acquired from failed institutions,
                    and U.S. Treasury and Federal Financing Bank (FFB) borrowing.3
                    Specifically, under the Federal Deposit Insurance Corporation
                    Improvement Act of 1991 (FDICIA), FDIC is authorized to borrow up to
                    $30 billion from the Treasury to cover BIF and SAIF losses. The Omnibus
                    Budget Reconciliation Act of 1990 (OBRA ’90) authorized FDIC to borrow
                    funds from FFB to finance the acquisition of failed bank and thrift assets.
                    Additional sources of financing available to SAIF include (1) borrowing
                    from the Federal Home Loan Banks, (2) up to $8 billion in Treasury funds
                    for losses sustained by SAIF in fiscal years 1994 through 1998, contingent
                    upon appropriations, and (3) unused funds appropriated to the Resolution
                    Trust Corporation (RTC) for 2 years following the termination of the RTC.




                    3
                     Funding to resolve the savings and loan crisis was provided primarily from taxpayers in the form of
                    general fund appropriations. We estimate the total direct and indirect cost of resolving the savings and
                    loan crisis to be $160 billion, of which approximately $132 billion (83 percent) will have been paid
                    using taxpayer funding sources. For a detailed analysis, see Financial Audit: Resolution Trust
                    Corporation’s 1995 and 1994 Financial Statements (GAO/AIMD-96-123, July 2, 1996).



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                           OBRA ’90 removed the caps on deposit insurance premium rate increases
                           and authorized FDIC to set BIF and SAIF premium rates semiannually. In
                           1991, a provision of FDICIA required FDIC to implement a risk-related
                           premium system and to build BIF and SAIF reserves to a minimum of
                           1.25 percent of total insured deposits within 15 years. BIF reached the
                           statutorily required reserve level in May of 1995. A special one-time
                           assessment of 68 cents per $100 of deposits in SAIF-insured institutions was
                           mandated by the Deposit Insurance Funds Act of 1996 to fund SAIF to the
                           required reserve level.4

                           Since January 1993, FDIC has assessed risk-related insurance premiums.
                           FDIC calculates risk-related assessments for individual banks and thrifts by
                           placing each institution in one of nine risk categories based on capital
                           ratios and supervisory ratings. Under this system, institutions will pay
                           assessment rates in 1997 of between 0 and 27 cents per $100 of insured
                           domestic deposits based on risk category. The average annual assessment
                           rate for BIF-insured institutions will be 0.17 cents per $100 insured deposits
                           and 0.6 cents per $100 insured deposits for SAIF members.


Current Budget Treatment   BIF and SAIF are reported separately but treated similarly in the budget. All
                           administrative and insurance expenses as well as revenue from premium
                           assessments, interest earnings, asset sales, and other fees flow through a
                           single budget account for each fund. All expenses of these accounts,
                           including administrative expenses and the expenses of FDIC’s Office of
                           Inspector General, are classified as mandatory under the Budget
                           Enforcement Act of 1990 (BEA). However, deposit insurance revenue and
                           spending are exempt from BEA pay-as-you-go restrictions. As such, any
                           additional spending necessary to maintain the safety and soundness of the
                           government’s deposit insurance commitment does not need to be offset by
                           tax increases or spending cuts in other direct spending. Similarly,
                           increases in insurance premiums or other deposit insurance collections
                           cannot be used to offset increased spending for other mandatory
                           programs. Budgeted and actual bank insurance outlays for fiscal years
                           1973 through 1996 are shown in figure II.1. Figure II.2 displays comparable
                           information for thrift insurance.




                           4
                            The act also spread responsibility for interest payments on bonds held by the Financing Corporation
                           (FICO) that were issued in 1987 through 1988 to finance the resolution of failed thrift institutions.
                           Previously, FICO interest payments were borne entirely by SAIF assessments. Beginning January 1,
                           1997, BIF-insured institutions will pay 1.29 cents and SAIF-insured institutions will pay 6.44 cents per
                           $100 of covered deposits. In the year 2000, all banks and thrifts will pay 2.43 cents per $100 of deposits.



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                                        Deposit Insurance




Figure II.1: Bank Deposit Insurance
Budget Estimates Versus Actual
                                        Nominal dollars in millions
Outlays, Fiscal Years 1973-1996
                                        50,000


                                        40,000


                                        30,000


                                        20,000


                                        10,000


                                              0


                                        -10,000


                                        -20,000
                                                   73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                                  Fiscal year

                                                                               Budget   Actual




Figure II.2: Thrift Deposit Insurance
Budget Estimates Versus Actual
Outlays, Fiscal Years 1973-1996         Nominal dollars in millions
                                        100,000


                                         80,000


                                         60,000


                                         40,000


                                         20,000


                                              0


                                        -20,000


                                        -40,000
                                                   73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                                  Fiscal year

                                                                               Budget   Actual




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                           Deposit Insurance




                           Budget Account: Credit Union Share Insurance Fund (CUSIF)
Credit Union Share                          (25-4468-0-3-373)
Insurance
                           Agency: National Credit Union Administration (NCUA)


Coverage                   The National Credit Union Administration insures members’ shares
                           (deposits) up to $100,000 per shareholder account in federal and
                           state-chartered credit unions that qualify for insurance. In fiscal year 1995,
                           NCUA insured $266 billion in deposits in approximately 12,000 credit
                           unions.


Eligibility Requirements   All federally chartered credit unions are required to be federally insured.
                           Most states prohibit credit unions from operating without any insurance
                           but allow nonfederally backed private insurance in lieu of federal
                           insurance. To be eligible for federal insurance, each applicant must be
                           approved by the NCUA board and agree to comply with all statutory and
                           regulatory requirements. These requirements include: the reporting of
                           financial and statistical information on a quarterly or semiannually basis to
                           NCUA, periodic examination as determined by NCUA, and the payment of
                           premium assessments. The NCUA board assesses each application for share
                           insurance based on (1) the history, financial condition, and management
                           policies of the applicant; (2) the economic advisability of insuring the
                           applicant without undue risk to the fund; (3) the general character and
                           fitness of the applicant’s management; (4) the convenience and needs of
                           the credit union’s members to be served; and (5) whether the applicant is a
                           cooperative association organized for the purpose of promoting thrift
                           among its members and creating a source of credit for provident or
                           productive purposes.


Program Financing          CUSIF is structured to be entirely self-supporting through monies provided
                           by member credit unions. The insurance program is financed primarily
                           from insurance premiums that may be assessed annually and from
                           mandatory credit union deposits in the insurance fund. The assessment
                           rate is set in statute (Public Law 91-468) at one-twelfth of 1 percent of a
                           credit union’s total member share accounts. Title VIII of Public Law 98-369
                           (July 18, 1984), which provided for the capitalization of the insurance
                           fund, requires each insured credit union to deposit and maintain in the
                           insurance fund an amount equal to 1 percent of its insured member
                           accounts. Other sources of funds include income generated from the



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                           investment of monies received from the insured credit unions and funds
                           received from the management and disposition of assets acquired from
                           failed institutions. CUSIF is authorized to borrow $100 million from the
                           Treasury at any time for the purpose of carrying out the insurance
                           program.

                           Public Law 98-369 also requires that the CUSIF balance be maintained at a
                           normal operating level to be determined by the NCUA board. The board has
                           determined this level to range from 1.25 percent to 1.3 percent of insured
                           shares. Since the recapitalization of the insurance fund in 1985, credit
                           unions have been assessed premiums in only 1 year, 1992. In 1996, CUSIF
                           paid a $106 million dividend to federally insured credit unions because the
                           fund balance exceeded the 1.3 percent reserve requirement.


Current Budget Treatment   All administrative and insurance expenses as well as revenue from
                           assessments, investment earnings, asset sales, and other fees flow through
                           a single budget account, the Credit Union Share Insurance Fund. All
                           expenses of this account including administrative expenses are classified
                           as mandatory under BEA. Like the funding provided through BIF and SAIF,
                           cost resulting from the government’s current insurance guarantee is
                           exempt from BEA controls. The CUSIF account reimburses NCUA’s Operating
                           Fund budget account for its share of the agency’s administrative costs. The
                           reimbursement percentage, which is reviewed and adjusted periodically, is
                           currently 50 percent. Budgeted and actual credit union insurance outlays
                           for fiscal years 1973 through 1996 are displayed in figure II.3.




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                                             Deposit Insurance




Figure II.3: Credit Union Share
Insurance Budget Estimates Versus
Actual Outlays, Fiscal Years 1973-1996       Nominal dollars in millions
                                                 0



                                              -200



                                              -400



                                              -600



                                              -800



                                             -1,000
                                                      73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                                     Fiscal year

                                                                                  Budget   Actual




                                             Numerous methodologies have been developed that attempt to forecast
Methods for Assessing                        the future financial condition of the bank and thrift industries which
Risk Assumed Under                           affects the condition of the deposit insurance funds. Subsequent sections
Deposit Insurance                            summarize the following major types of models:

                                         •   OMB’s options pricing,
                                         •   actuarial,
                                         •   transition matrix,
                                         •   asset markdown,
                                         •   proportional hazards, and
                                         •   pro forma projection.

                                             Only one of the methodologies—options pricing—provides accrued cost
                                             estimates for the funds in its present form. In general, the alternative
                                             models provide forecasts of future bank and thrift insolvencies which can
                                             be used to estimate accrued costs. However, the options pricing approach
                                             developed by OMB estimates the accruing cost to the insurance funds by
                                             drawing the analogy between the price of a put option and actuarially fair
                                             insurance premiums.




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                        The methodologies described in this section have been developed and/or
                        used by various federal agencies and private forecasters. For example, OMB
                        has been using its options-based methodology for several years to project
                        the condition of the bank and thrift insurance funds and to develop budget
                        estimates. OMB does not rely exclusively on the estimates generated by its
                        options approach. It consults with FDIC, Treasury, and the Federal Reserve
                        on their near and long-term projections. FDIC, in turn, relies on several
                        methodologies in preparing loss estimates for purposes of updating the
                        recapitalization schedules of the insurance funds and the agency’s
                        financial statements. Methodologies used by FDIC include actuarial models,
                        pro forma analyses, and proportional hazard models.

                        While the methodologies differ considerably in their approach and
                        assumptions, they all rely to some extent on financial data supplied by
                        institutions to their federal regulator (call report data). We have reported
                        on several occasions that these data cannot always be depended upon to
                        provide an accurate picture of the value of an institution’s assets.5 Because
                        of this, most loss estimation methodologies adjust call report data to
                        attempt to approximate the economic or market value of an institution’s
                        assets. Based on this estimated asset value and the value of an institution’s
                        deposit and other liabilities, the solvency of an institution is calculated as
                        are resulting losses to the government insurance funds from failed
                        institutions. In a prior review of loss estimation methodologies, we
                        emphasized that long-range estimates of bank failures and their impact on
                        the insurance fund is a highly subjective process dependent on many
                        variables, such as interest rates, which are extremely difficult to predict.6


OMB’s Options Pricing   OMB  has developed a model based on options pricing theory7 to estimate
Model                   the government’s cost of deposit insurance. In the options pricing
                        framework, the government’s cost of deposit insurance is dependent on
                        the probability that a financial institution will exercise its option to
                        transfer its deposit liabilities to the government. This occurs only if the
                        value of the institution’s assets is lower than the value of its liabilities, at
                        which point the institution is technically insolvent. In other words, the


                        5
                         For additional discussion see Failed Banks: Accounting Reforms Urgently Needed (GAO/AFMD-91-43,
                        April 22, 1991), Credit Unions: Reforms for Ensuring Future Soundness (GAO/GGD-91-85, July 10,
                        1991), and Credit Unions: Both Industry and Insurance Fund Appear Financially Sound
                        (GAO/T-GGD-94-142, September 29, 1994).
                        6
                         Bank Insurance Fund: Review of Loss Estimation Methodologies (GAO/AIMD-94-48, December 9,
                        1993).
                        7
                         See figure 5.1 for a description of options pricing theory.



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Deposit Insurance




cost of the government’s deposit insurance commitment is directly related
to the probability that an institution will go bankrupt. Using options
pricing techniques, OMB is able to estimate the full risk-based premium of
deposit insurance based on a relatively few variables. These are (1) the
current value of the institutions’ assets, (2) the volatility in the value of the
assets, (3) the ratio of the institutions’ assets to liabilities in the
future—the exercise price of the option, (4) the time to expiration of the
option, and (5) the risk-free interest rate of corresponding duration. The
government’s cost of the deposit insurance commitment is then calculated
as the difference between the actuarially fair premium (price of the
option) and the actual premiums collected.8

The general application of options pricing theory presumes that current
asset values can be readily observed and measured. In practice, most
common applications of options pricing models rely on asset market
prices to compute the value of the option. However, there is no active
market for the assets—loans—of financial institutions. Some researchers
have used stock prices of large publicly traded institutions, however, the
stock of many insured institutions is not actively traded. Therefore, in
order to estimate the government’s cost of insuring all institutions, OMB
must first infer the market value of individual institutions from call report
data.

OMB uses call report data to estimate the market value of each depository
institution with assets over $100 million and subsidiaries of bank and thrift
holding companies with assets over $500 million. The market value of each
institution’s assets is estimated by capitalizing9 its adjusted gross earnings
net of taxes and interest earned but not collected. OMB makes two
adjustments to reported earnings before estimating the market value.
First, because an institution’s provision for loan losses tends to be erratic
and subject to lags, OMB substitutes an estimated loss provision for each
bank based on recent loss experience of similar institutions. Second,
earnings are adjusted to account for the tendency of very high or low
reported earnings to revert toward the industry’s long-term mean rate of
return. OMB uses a simple regression model, with estimated coefficients for

8
 For a detailed description of the model, see Richard L. Cooperstein, George G. Pennacchi and F.
Stevens Redburn, “The Aggregate Cost of Deposit Insurance: A Multiperiod Analysis,” Journal of
Financial Intermediation, vol. 4, no. 3 (July 1995), pp. 242-271.
9
 Capitalization refers to a method of valuing a firm based on the cash it generates. First, future
earnings over a reasonable number of years must be estimated. Second, estimated earnings are
adjusted for non-cash consuming or generating items, such as depreciation, to determine annual cash
flows. Third, capital outlays required to support the current level of earnings are estimated. The
resulting cash flows are discounted at an appropriate interest rate. The resulting net present value
represents an estimate of the value of the firm.



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                   four classes of banks, to forecast future cash flows. The resulting estimate
                   of an institution’s current asset value, less the face value of its deposits
                   and other liabilities, provides an estimate of net worth.

                   OMB uses the estimated net worth of approximately 3,000 insured
                   institutions as input to its options pricing model. As mentioned above, the
                   estimated current and future net worth of an institution are key variables
                   in determining the value of the option—and ultimately the government’s
                   cost of deposit insurance. For future periods, OMB uses a stochastic10
                   simulation process to forecast the future net worth of individual
                   institutions. The simulation does not project the performance of actual
                   institutions. Instead, OMB takes the actual measured distribution of
                   economic net worth of the banking or thrift industries and breaks up the
                   distribution into 8,000 equal-sized fictitious institutions. This is the
                   statistical equivalent of averaging many independent projections.

                   Over a chosen simulation period, such as a 5- or 7-year budget horizon, the
                   financial condition of some institutions improves and others declines.
                   Assumptions about the volatility of asset earnings and expected trends in
                   average industry earnings are significant determinants of the value of the
                   option and simulated flow of costs. OMB assumes constant volatility of
                   assets across banks of the same size and stability over the simulation
                   period based on the experience of a sample of banks from 1984 through
                   1990. The simulation yields annual estimates of the volume of financial
                   institution assets that will be closed if the regulators continue to follow
                   recent or other specified closure behavior. Closure is defined in terms of
                   the asset to liability ratio of an institution. The government’s cost of
                   deposit insurance is calculated as losses resulting from newly insolvent
                   institutions, additional deterioration in previously identified insolvent
                   institutions, and increases in the risk of failure of solvent firms—offset by
                   improvements in the financial condition of any institutions. These costs
                   less premiums collected constitute the net cost to the government.


Actuarial Models   Actuarial models use historical frequencies of resolution for categories of
                   banks as an estimate of the probability of resolution for the current
                   population of banks in some future period. This approach assumes that
                   recent failure rates will continue in the future. Actuarial models do not
                   identify specific banks that are likely to fail nor do they provide the

                   10
                    A stochastic or random process is one in which only chance factors determine the particular
                   outcome of a single run through the process or trial. The possible outcomes are known in advance, but
                   not the exact outcome of any one trial. The process does have some regularity, which allows a
                   probability to be assigned to possible outcomes.



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                           specific timing of resolutions. These models are a top-down descriptive
                           statistical approach to estimating future resolutions.

                           Using an actuarial approach, a table is constructed to categorize the entire
                           population of banks or thrifts based on characteristics such as size (value
                           of assets), capitalization ratios, nonperforming assets, loan loss reserves,
                           and geographic location. The probability of resolution over a finite time
                           period for each category of institutions is estimated from the incidence of
                           resolution during a historical period of similar length. A separate loss
                           distribution function is used to make annual projections of resolved bank
                           or thrift assets.


Transition Matrix Models   Transition matrix models are a variation of actuarial models that use the
                           relative incidence of the movement of the number and assets of banks or
                           thrifts across CAMEL11 categories to determine subsequent year CAMEL
                           ratings and resolutions. Like actuarial models, transition matrix models do
                           not identify individual bank or thrift failures but simply project a future
                           distribution of failed institutions.


Asset Markdown Models      Asset markdown models attempt to estimate the net worth of every
                           institution in the industry. This is accomplished by (1) using asset
                           deflators to explicitly value assets and equity of individual banks or
                           (2) discounting cash flows after adjusting for potential loan losses,
                           nonperforming loans, expenses, and reserves. Banks with negative net
                           worth based on the estimated market value of assets and equity are
                           identified. The results are used to produce an estimate of embedded
                           (future) losses to the insurance fund. The data-intensive nature of this
                           approach limits its application.


Proportional Hazards       Proportional hazards models are based on the premise that certain
Models                     financial and economic variables determine a financial institution’s risk of
                           failure and thus affect its time-to-failure. This type of an approach
                           attempts to estimate the time-to-failure using bank attributes and other
                           variables in a regression model. The model generates the probability that a
                           bank will survive beyond any given time period. A probability distribution
                           of an institution’s expected life can be plotted for a range of future time

                           11
                             CAMEL ratings are a numerical index of financial condition used by bank regulators based on on-site
                           examinations and examiners’ assessment of risk. The five components of a CAMEL rating are capital
                           adequacy, asset quality, management practices, earnings, and liquidity. CAMEL ratings range from 1
                           for financially sound banks to 5 for unsound banks.



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                           Appendix II
                           Deposit Insurance




                           periods. A proportional hazards model developed by FDIC analysts used
                           seven bank and economic variables.12 These variables were two regulatory
                           indicators of a bank’s financial stress and measures of a bank’s capital
                           level, riskiness of assets, asset quality relative to reserves, profitability,
                           and a leading economic indicator—the annual percentage change in
                           housing permits at the state level.


Pro Forma Projection       This type of model projects individual bank or thrift income and capital
Models                     based on current conditions. An institution’s earnings are based on returns
                           to current earning assets. Assumptions are made regarding the movement
                           of nonperforming assets based on the expected macroeconomic
                           conditions. Liabilities can be modeled under optimistic or pessimistic
                           scenarios. Assumptions are also made about earnings retention and
                           nonperforming loans and charge-offs.



Implementation
Considerations for
Deposit Insurance

Adequacy of Current        The cash-based budget’s focus on cash flows can make deposit insurance
Budget Reporting           look profitable when costs are rising or look more costly when there has
                           been no change in actual costs. This is because:

                       •   Cash-based budget reporting does not recognize the cost of a failed
                           institution until cash is required to pay off depositors, which may not
                           occur until months or years after an institution becomes insolvent.
                       •   The cost of new or growing deposit insurance commitments are not
                           recognized in the budget when they occur.
                       •   The government’s cost for deposit insurance is obscured by the recording
                           of financing (working capital) transactions. When the government closes
                           an institution and pays its depositors, it acquires assets which are
                           subsequently sold. The cash-based budget records the cash needed to
                           acquire the assets as an outlay and the proceeds of asset sales as offsetting
                           collections. The government’s cost—the difference between what it paid



                           12
                            For more information, see Gary S. Fissel, “Risk Measurement, Actuarially-Fair Deposit Insurance
                           Premiums and the FDIC’s Risk-Related Premium System,” FDIC Banking Review, vol. 7, no. 1
                           (Spring/Summer 1994), pp. 16-27.



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                                Appendix II
                                Deposit Insurance




                                for the assets and what it was able to sell them for—is not shown in the
                                budget.


Issues in Implementing an   •   Estimates of future bank failures and their impact on the deposit
Accrual-Based Budgeting         insurance funds are inherently uncertain due to their dependence on
Approach for Deposit            uncertain economic conditions, firm behavior, and industry changes.
                            •   Methodologies currently available for estimating the accrual cost of
Insurance                       deposit insurance are generally based on recent program experience and
                                may not capture the long-term risk to the government.
                            •   The uncertainty inherent in accrual cost estimates and reestimates for
                                deposit insurance could potentially introduce new volatility in the annual
                                reported program cost and the budget deficit.




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Appendix III

Pension Insurance


               Budget Account: Pension Benefit Guaranty Corporation Fund
                                (16-4204-0-3-601)

               Agency: Pension Benefit Guaranty Corporation (PBGC)


Purpose        The Pension Benefit Guaranty Corporation (PBGC) was established by Title
               IV of the Employee Retirement Income Security Act of 1974 (ERISA) to
               protect the retirement income of participants and beneficiaries covered by
               private sector, defined benefit pension plans. These plans provide a
               specified monthly benefit at retirement, usually based on salary or a stated
               dollar amount and years of service. PBGC usually assumes responsibility for
               paying insured retirement benefits when a plan sponsor experiences
               severe financial stress and cannot pay all promised benefits. This generally
               occurs only when an employer is being liquidated or, if after filing for
               bankruptcy protection, it is determined that termination of the pension
               plan is necessary for the company’s survival. Under certain circumstances,
               PBGC can also terminate a plan and assume responsibility for plan benefits
               if, for example, the plan fails to meet minimum funding requirements or
               cannot pay current benefits.


Coverage       At the end of fiscal year 1996, PBGC insured the pension benefits of nearly
               42 million workers and retirees in approximately 50,000 private sector,
               defined benefit pension plans. Defined contribution plans, such as 401(k)
               plans, are not insured. PBGC administers two legally distinct programs, one
               for pension plans sponsored by a single employer and one for plans to
               which several companies make payments. These multiemployer plans are
               collectively bargained by industry or trade groups and generally cover a
               particular geographical area. Multiemployer plans account for
               approximately 2,000 of the 50,000 plans insured by PBGC.

               PBGC  guarantees the basic monthly retirement benefit of insured workers.
               The guarantee includes benefits beginning at normal retirement age
               (usually 65), certain early retirement and disability benefits, and benefits
               for survivors of deceased plan participants. PBGC guarantees only vested
               benefits.1 In addition, ERISA sets a limit for guaranteed benefits based on a
               formula which is adjusted periodically for growth in wages. For pension
               plans taken over by PBGC in 1997, the maximum annual pension guarantee
               is $33,136. Once the insured benefit amount is determined, it is not

               1
                Vested benefits are those to which an employee is entitled as the result of having met certain
               requirements, such as length of employment, even if the employee ceases employment prior to
               retirement.



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                           Appendix III
                           Pension Insurance




                           subsequently adjusted for inflation. In fiscal year 1996, PBGC paid benefits
                           of $792 million to approximately 200,000 retirees.


Eligibility Requirements   Under ERISA, employers who provide defined benefit pension plans must
                           meet minimum standards and provide prudent management of pension
                           funds. The standards specify who must be covered, how long a person has
                           to work to be eligible for benefits, and how much money must be
                           contributed annually by the employer to the plan. ERISA excludes certain
                           defined benefit plans from coverage. These include professional service
                           plans that cover fewer than 26 participants, plans of fraternal societies
                           financed entirely by member contributions, and plans maintained
                           exclusively for substantial owners of a business.


Program Financing          PBGC  is required by ERISA to be self-financing on an actuarial basis. PBGC
                           receives funds from premiums collected from ongoing pension plans,
                           investment income, terminated plan assets, and recoveries from sponsors
                           of terminated plans. PBGC is also authorized to borrow up to $100 million
                           from the U.S. Treasury in the event that its resources are insufficient to
                           pay guaranteed benefits. At the end of fiscal year 1996, PBGC’s financial
                           statements reflected a surplus $993 million. This was the first time since it
                           was created that the agency has posted a surplus.

                           Annual premiums for the single-employer programs are $19 per participant
                           for a fully funded plan. Underfunded single-employer plans pay an
                           additional variable rate of $9 per participant for each $1,000 of unfunded
                           vested benefits. Prior to passage of the Retirement Protection Act of 1994
                           (RPA) the variable rate was capped at $53 per participant. The cap is being
                           phased out under RPA over a 3-year period which began July 1, 1994. The
                           multiemployer plan premium is $2.60 per participant.


Current Budget Treatment   Prior to 1981, PBGC was treated as an off-budget federal entity and as such
                           its transactions were excluded from the budget totals. Beginning in 1981,
                           Public Law 96-364 required that PBGC’s receipts and disbursements be
                           included in the budget. The on-budget activities of PBGC are reported in a
                           single account. Outlays from this account are classified as mandatory
                           under BEA with the exception of administrative expenses, which are
                           discretionary. Figure III.1 shows the budgeted and actual outlays of PBGC’s
                           on-budget account since 1981.




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                                         Pension Insurance




Figure III.1: Pension Benefit Guaranty
Corporation Budget Estimates Versus
Actual Outlays, Fiscal Years 1981-1996   Nominal dollars in millions
                                             0


                                          -200


                                          -400


                                          -600


                                          -800


                                         -1,000


                                         -1,200


                                         -1,400


                                         -1,600
                                                    81   82    83      84   85   86   87    88     89    90   91   92   93   94   95   96
                                                                                           Fiscal year

                                                                                      Budget      Actual




                                         The budget treatment of PBGC is complicated by the use of a second
                                         account for some activities which is not included in the federal budget.
                                         This account records the assets and liabilities that PBGC acquires from
                                         terminated plans. As a result, the budget only reports PBGC’s net annual
                                         cash flows between its on-budget account and all other entities—including
                                         the other PBGC account. It does not provide information on liabilities PBGC
                                         incurs when it takes over an underfunded plan or other changes in PBGC’s
                                         assets and liabilities.


                                         Calculation of the risk-assumed cost of the government’s pension
Methods of Assessing                     insurance has focused on two methods. The first, developed by OMB staff,
Risk Assumed for                         uses a mathematical model based on options pricing theory. The second
Pension Insurance                        method is a simulation approach based on the research of two economists
                                         at the Federal Reserve Bank of New York and developed and refined by
                                         PBGC staff.



OMB’s Options Pricing                    As part of the Bush administration’s 1992 proposal to implement
Model                                    accrual-based budgeting for federal insurance programs, OMB staff
                                         developed an options pricing approach to estimate PBGC’s risk-assumed



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                           Appendix III
                           Pension Insurance




                           liability and annual accruing cost. Options pricing is commonly used by
                           financial markets to estimate the future value of various types of assets. A
                           brief overview of options pricing theory is provided in figure 5.1. In OMB’s
                           model, the pension guarantee is treated as giving the owners of a firm the
                           option to transfer their pension plan liabilities to PBGC when the firm
                           becomes insolvent. However, since the cost to the government is
                           contingent on the financial conditions of both the pension plan and the
                           plan’s sponsoring firm, OMB’s model specifies stochastic processes for
                           projecting the value of the assets and liabilities of the pension plan and the
                           sponsoring firm.2

                           OMB’s model uses actual stock and financial data on sponsoring firms and
                           their pension plans. Data used include company stock price information
                           and pension plan assets and liabilities. Data from approximately 1,800
                           individual companies representing approximately 70 percent of the
                           single-employer pension liability insured by PBGC is used. OMB’s model is
                           limited to publicly traded firms that sponsor defined benefit pension plans.
                           Assumptions are made about the growth rates of pension assets and
                           liabilities, PBGC recovery rates from bankrupt firms, and plan participation
                           rates. In addition, a number of parameters are estimated based on recent
                           experience to characterize changes in the asset-to-liability ratios of the
                           firms and pension plans.

                           Using data on the current financial conditions of pension plans, plan
                           sponsors, and information on recently observed changes, OMB’s model
                           solves a series of simultaneous differential equations to estimate the
                           probability of bankruptcy and plan underfunding for individual insured
                           pension plans. The model then calculates the cost of PBGC’s potential
                           losses resulting from the projected terminated underfunded plans and the
                           value of the potential insurance premiums that PBGC will collect. Together,
                           these calculations provide the net cost to the government of the pension
                           guarantee or subsidy extended to the pension plans in the model. A
                           separate amortization schedule is used to spread this cost on an annual
                           basis based on the increase in vested guaranteed benefits.


PBGC’s Pension Insurance   Around the time that OMB unveiled its model, PBGC began developing a
Modeling System            simulation approach to forecast its exposure to future claims under a wide
                           range of possible future economic conditions. PBGC’s efforts built upon


                           2
                            For a detailed description of the model, see George G. Pennacchi and Christopher M. Lewis, “The
                           Value of Pension Benefit Guaranty Corporation Insurance,” Journal of Money, Credit, and Banking,
                           vol. 26, no. 3 (August 1994, part 2), pp. 735-753.



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Pension Insurance




earlier research of economists at the Federal Reserve Bank of New York.3
The model, which PBGC calls the Pension Insurance Modeling System
(PIMS), is designed to simulate pension funding and bankruptcy rates over
a 30-year period. The model, which is still under development, generates
estimates of average expected claims and probability measures of the
uncertainty surrounding the estimates under various economic and policy
scenarios.4 PBGC expects to use this information to analyze its exposure to
future losses and evaluate various legislative changes in the pension
insurance program and related laws.

The heart of PIMS is the simulation of a series of dynamic relationships that
characterize the growth of firm assets and liabilities, the number of plan
participants, the assets and liabilities of the pension plan, and the normal
cost associated with the plan. The pension plan and the sponsoring firm
are treated as separate but related entities. The future financial condition
of the firm and plan are interdependent and also dependent on current
financial conditions, legal and regulatory restrictions, and uncertainty of
future economic conditions. Stochastic variables are used to model this
uncertainty. The model simulates these dynamic relationships over a
specified period of time. In order to forecast future expected claims, the
model is run a large number of times to produce a distribution of possible
outcomes. This provides an estimate of the average expected future claims
and a measure of the probability that actual claims will be within a certain
range around the estimate.

PIMS is data-intensive, using numerous attributes of individual pension
plans and sponsoring firms. The model is run using a stratified sample of
firms. PBGC currently has data on 266 plans representing approximately
50 percent of the government’s liability and 50 percent of plan
underfunding in PIMS. Model results can be extrapolated to account for the
entire population of plan sponsors. For each plan in PIMS, Internal Revenue
Service funding requirements are modeled. The probability of firm
bankruptcy is also modeled and is dependent upon several factors,
including company size, industry, and firm characteristics. All parameters
in the model are empirically based. PBGC, working with outside reviewers,
has been conducting extensive testing of PIMS over the past year.



3
 Arturo Estrella and Beverly Hirtle, “Estimating the Funding Gap of the Pension Benefit Guaranty
Corporation,” Federal Reserve Bank of New York Quarterly Review, vol. 13, no. 3 (Autumn 1988), pp.
45-59.
4
 For a detailed discussion, see Richard Ippolito and William Ross eds., Pension Insurance Modeling
System, draft report presented at the Pension Research Council, PIMS Technical Review Panel, at the
Wharton School of the University of Pennsylvania, November 1996.


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Implementation
Considerations for
Pension Insurance

Adequacy of Current         •   PBGC’s  annual net cash flows reported in the budget reduce the annual
Budget Reporting                budget deficit while its growing long-term commitment to pay pension
                                benefits has no effect on the deficit.
                            •   Liabilities from terminated, underfunded pension plans taken over by PBGC
                                are not recognized in the budget.
                            •   The government’s exposure to future claims from insuring currently
                                healthy firms—the risk assumed by the government—is not recognized in
                                the budget.
                            •   Changes in the government’s exposure to future claims due to the annual
                                growth in insured benefits or program changes are not recognized in the
                                budget as they occur.


Issues in Implementing an   •   Estimates of PBGC’s exposure to the future costs of pension benefits are
Accrual-Based Budgeting         inherently uncertain due to its sensitivity to changes in interest rates and
Approach                        the difficulty of projecting firm bankruptcies.
                            •   Potentially large annual swings in the accruing cost of pension guarantees
                                due to changes in economic conditions could introduce new volatility in
                                the annual budget deficit.
                            •   Development, testing, and documentation of both the OMB model and
                                PBGC’s PIMS is not yet complete.




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Appendix IV

Other Insurance Programs


                               The federal government provides life insurance coverage to employees,
Federal Life Insurance         retirees, and veterans.1 The following sections provide an overview of the
                               three life insurance programs included in our study:

                           •   Federal Employees’ Group Life Insurance
                           •   Service-Disabled Veterans Insurance
                           •   Veterans Mortgage Life Insurance


Federal Employees’ Group       Budget Account: Employees’ Life Insurance Fund
Life Insurance                                  (24-8424-0-8-602)

                               Agency: Office of Personnel Management (OPM)

                               Bureau: Retirement and Insurance Service (RIS)

Purpose                        The Federal Employees’ Group Life Insurance (FEGLI) program was
                               established in 1954 (Public Law 83-598) to provide federal employees the
                               opportunity to obtain low-cost term life insurance comparable to that
                               widely offered by private sector employers. The establishment of the
                               program was seen as an essential element of a well-rounded personnel
                               program for the federal government. The Office of Personnel Management
                               (OPM) manages FEGLI, sets and collects insurance premiums, and invests
                               program funds. The Metropolitan Life Insurance Company, under contract
                               with OPM, settles and pays insurance claims. Prior to the establishment of
                               FEGLI, life insurance coverage was offered to groups of federal employees
                               by beneficial associations. With the creation of FEGLI, membership in these
                               associations was closed.2

Coverage                       FEGLI covers 90 percent of eligible employees and retirees of the executive,
                               legislative, and judicial branches of the federal government as well as
                               many of their family members. Basic coverage is automatic upon eligibility
                               unless declined by the employee. At the end of fiscal year 1996, $484
                               billion3 in life insurance coverage was provided under FEGLI to 2.4 million



                               1
                                Only veterans’ life insurance programs underwritten by the federal government and still open to new
                               participants were included in this study.
                               2
                                In 1955, the Congress authorized OPM to purchase a qualified insurance policy to insure agreements
                               assumed from the beneficial associations. This very small program is underwritten by the Shenandoah
                               Life Insurance Company.
                               3
                                Includes $113 billion for accidental death and dismemberment (AD&D) coverage. In prior years, OMB
                               excluded AD&D coverage from the reported FEGLI face value.



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                           Appendix IV
                           Other Insurance Programs




                           active employees and about 1.6 million annuitants. Total insurance in
                           force is projected to increase to $496 billion by the end of fiscal year 1998.

                           The FEGLI program provides basic life insurance coverage equal to the
                           employee’s annual salary rounded to the next higher $1,000, plus $2,000.
                           The minimum coverage is $10,000 and the maximum is limited to the
                           amount based on the Level II Executive Schedule salary. For accidental
                           death, the amount is doubled. One-half the basic benefit is payable for
                           accidental dismemberment—the loss of one hand, one foot, or one
                           eye—while the full benefit is paid for the loss of two or more such
                           members. Employees age 35 or under receive insurance coverage equal to
                           twice the basic amount at no additional cost to them. This extra benefit
                           decreases by 10 percent each year until at age 45 there is no extra benefit.
                           This extra benefit does not apply to the accidental death and
                           dismemberment benefit. Effective July 25, 1995, the FEGLI Living Benefits
                           Act of 1994 (Public Law 103-409) established a new provision allowing
                           terminally ill enrollees with life expectancies of 9 months or less to elect
                           to receive a lump-sum payment equal to their basic insurance amount with
                           some adjustments. Employees with basic FEGLI coverage are eligible to
                           purchase additional optional insurance coverage.

                           If certain conditions are met, full basic coverage is provided to retirees
                           until age 65. After age 65, three levels of coverage are available. If no
                           action is taken, the basic coverage amount is reduced by 2 percent each
                           month until 25 percent of the original coverage remains. However, retirees
                           may elect to purchase one of two alternatives for post-age 65 coverage.
                           They can elect (1) coverage that is reduced by 1 percent each month after
                           age 65 until it reaches 50 percent of the original amount or (2) no
                           reduction in coverage after age 65. If basic life insurance coverage is
                           continued into retirement, the optional insurance coverage may also be
                           continued at an additional cost to the retiree. Accidental death and
                           dismemberment coverage stops at retirement.

Eligibility Requirements   Most civilian employees of the federal government (and individuals first
                           employed by the District of Columbia government before October 1,
                           1987) are eligible to participate in the FEGLI program. Basic life insurance
                           coverage is effective on the first day of pay and duty status unless waived
                           by the employee. Employees are also eligible for optional coverage at this
                           point, but it is not effective until elected by the employee. Employees
                           working under temporary appointments are not eligible.




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                           Appendix IV
                           Other Insurance Programs




Program Financing          The FEGLI program is financed by insurance premiums and interest earned
                           on Treasury securities held by the insurance fund. Employees pay
                           two-thirds of the insurance premium for basic insurance coverage and
                           agencies pay the remaining third except for the Postal Service which pays
                           the full premium for its employees. The cost of optional insurance is paid
                           entirely by the employee or annuitant. Federal retirees, including Postal
                           Service retirees under age 65 who retired after 1989, also pay two-thirds of
                           the basic premium. After age 65, retirees pay nothing for coverage equal to
                           25 percent of the original basic benefit. The retiree pays premiums to
                           continue coverage at the full basic benefit level or at the 50-percent level.

                           In fiscal year 1996, the Employees’ Life Insurance Fund collected
                           premiums of approximately $1.5 billion and had investment income of
                           over $1.2 billion. During this period, the program paid approximately
                           $1.6 billion in insurance benefits. Although the FEGLI program is expected
                           to continue to have a positive cash flow for the next 15 years, the program
                           reported a $3.4 billion unfunded liability at the end of fiscal year 1996.

Current Budget Treatment   All administrative and insurance outlays as well as collections from
                           insurance premiums and earnings on invested funds are reported on a
                           cash basis in the Employees’ Life Insurance Fund—a trust revolving fund.
                           Associated with this fund is a payment account: Government Payment for
                           Annuitants, Employees’ Life Insurance. This payment account is used to
                           transfer to the fund appropriations received from the Congress to cover
                           the government’s share (one-third of the cost) of basic life insurance
                           premiums for certain federal annuitants.4 All FEGLI program costs are
                           classified as mandatory spending and all administrative costs are classified
                           as discretionary. Figure IV.1 shows budgeted and actual outlays for the
                           fund since 1973.




                           4
                            Annuitants under age 65 retiring after December 31, 1989.



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                                         Appendix IV
                                         Other Insurance Programs




Figure IV.1: Employees’ Life Insurance
Fund Budget Estimates Versus Actual
Outlays, Fiscal Years 1973-1996          Nominal dollars in millions
                                             0


                                          -200


                                          -400


                                          -600


                                          -800


                                         -1,000


                                         -1,200


                                         -1,400
                                                  73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                                 Fiscal year

                                                                              Budget   Actual




Service-Disabled Veterans                Budget Account: Service-Disabled Veterans Insurance Fund
Insurance                                                 (36-4012-0-3-701)

                                         Agency: Department of Veterans Affairs (VA)

                                         Bureau: Veterans Benefits Administration (VBA)

Purpose                                  Service-Disabled Veterans Insurance (SDVI) was established in 1951 under
                                         the Serviceman’s Indemnity Act to provide life insurance coverage to
                                         veterans having service-connected disabilities at the same rates available
                                         to nondisabled veterans.

Coverage                                 Under the SDVI program, life insurance is available to service-disabled
                                         veterans in multiples of $500 with minimum coverage set at $1,000 and the
                                         maximum set at $10,000. Under Public Law 102-568, totally disabled
                                         veterans may purchase supplemental insurance coverage not to exceed
                                         $20,000. Policyholders may borrow up to 94 percent of the cash value of
                                         their policies. Insurance in force at the end of fiscal year 1996 totaled
                                         approximately $1.5 billion covering 163,053 veterans.




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                           Appendix IV
                           Other Insurance Programs




Eligibility Requirements   Any person who is released from active military service, under conditions
                           other than dishonorable, on or after April 25, 1951, and is found by the
                           Secretary of Veterans Affairs to be suffering from a service-connected
                           disability or disabilities, is eligible to apply for coverage. A disabled
                           veteran must complete a written application within 2 years from his or her
                           discharge date to be granted coverage. Veterans who are determined to be
                           totally disabled are eligible to apply for supplemental insurance.

Program Financing          The program is financed from premiums, interest on policy loans, and
                           general funds received by transfer from the Veterans Insurance and
                           Indemnities appropriation. The premiums charged for this coverage are
                           based on standard rates for nondisabled individuals. Premiums for totally
                           disabled veterans are waived. Totally disabled veterans who apply for
                           supplemental insurance pay premiums for the additional coverage.
                           Because of these provisions, premiums are not actuarially sound and the
                           program is not self-sufficient. At the end of fiscal year 1996, the program’s
                           liability for future benefits exceeded available assets by $457 million. This
                           deficit is expected to remain approximately at this level through the end of
                           fiscal year 1997.

Current Budget Treatment   All cash flows of the program with the exception of administrative
                           expenses are reported on a cash basis in the Service-Disabled Veterans
                           Insurance Fund. These cash flows include premium collections, payment
                           of death claims, payment of cash value of policies surrendered,
                           disbursement of policy loans, interest on loans, and repayment of loans.
                           This account also receives a transfer of funds from the Veterans Insurance
                           and Indemnities appropriation account as needed to cover outlays. All
                           activity of this account is classified as mandatory under BEA. The
                           program’s administrative expenses are paid out of the Department of
                           Veterans Affairs (VA) General Operating Expenses appropriation and are
                           discretionary. Figure IV.2 shows budgeted and actual outlays for the SDVI
                           fund since 1973.




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                                         Appendix IV
                                         Other Insurance Programs




Figure IV.2: Service-Disabled Veterans
Insurance Fund Budget Estimates          Nominal dollars in millions
Versus Actual Outlays, Fiscal Years      15
1973-1996

                                         10



                                          5



                                          0



                                          -5



                                         -10
                                               73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                               Fiscal year

                                                                             Budget   Actual




Veterans Mortgage Life                   Budget Account: Veterans Insurance and Indemnities
Insurance                                                 (36-0120-0-1-701)

                                         Agency: Department of Veterans Affairs (VA)

                                         Bureau: Veterans Benefits Administration (VBA)

Purpose                                  Veterans Mortgage Life Insurance (VMLI) was established in 1971 (Public
                                         Law 92-95) to provide mortgage protection life insurance to severely
                                         disabled veterans who are granted VA assistance in securing specially
                                         adapted housing.

Coverage                                 The amount of insurance provided to a veteran under this program is the
                                         lesser of $90,000 or the amount of the loan outstanding on the housing
                                         unit. The amount of insurance is reduced according to the amortization
                                         schedule of the loan and may not at any time exceed the amount of the
                                         outstanding loan with interest. If there is no loan outstanding on the
                                         housing unit, no insurance is available under this program.

Eligibility Requirements                 Severely disabled veterans who have received VA grants for specially
                                         adapted housing are automatically insured against death unless the




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                            Appendix IV
                            Other Insurance Programs




                            veteran declines coverage in writing to the Secretary of the VA or fails to
                            provide the VA with the necessary information on which to calculate the
                            insurance premium. A veteran who elects not to be insured can
                            subsequently obtain insurance upon submission of an application.

Program Financing           The program is financed by premiums paid by policy holders and general
                            fund appropriations. Under law, the premium rates charged to eligible
                            veterans are based on mortality data that are appropriate to cover only the
                            cost of insuring nondisabled persons. As a result, the program is not
                            self-supporting and requires appropriated funds to pay claims to mortgage
                            holders. At the end of fiscal year 1996, VA estimated that the VMLI program’s
                            liability for future benefits exceed available assets by $93 million.

Current Budget Treatment    All activities including premium collections and claim disbursements of
                            the VMLI program are recorded on a cash basis in the Veterans Insurance
                            and Indemnities appropriation account. The program has permanent
                            authority and appropriations are made as needed to cover claims. This
                            account is classified as mandatory under BEA. The program’s
                            administrative expenses are paid out of the VA’s General Operating
                            Expenses appropriation and are discretionary.


Methods of Assessing Risk   Officials at VA and OPM currently use actuarial approaches that are the
Assumed for Life            standard practice of the life insurance industry. Measurement of the risk
Insurance                   assumed in insuring lives is well established in actuarial science. Mortality
                            tables, which are mathematical models based on the laws of probability
                            and mortality statistics, provide the basis for estimating the occurrence of
                            future deaths. This information together with assumptions about interest
                            rates and contractual policy benefits allow for the calculation of expected
                            insurance claims.

                            A basic principle of actuarial science holds that, by studying the rate of
                            death within any large group of people and gathering information on all
                            factors that may affect that rate, it is valid to anticipate that any future
                            group of persons with approximately the same factors will experience the
                            same rate of death. Mortality tables are constructed to reflect probabilities
                            of death at each age. The accuracy with which the estimated future claims
                            approximates the actual experience depends upon two factors: (1) the
                            accuracy and appropriateness of the underlying mortality statistics and
                            (2) the number of observations the estimate is based on and the number of
                            individuals insured. Most mortality tables in use today are based upon the




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Appendix IV
Other Insurance Programs




experience of insured individuals because of the accuracy and
completeness of data on these lives.

In the construction of mortality tables, adjustments are generally made to
the observed mortality rates. For example, actuaries have derived
mathematical formulas that attempt to explain mortality rates. These
formulas, which have gained general acceptance in the field, are used to
smooth unexplained deviations in observed mortality data. These formulas
are also used where data are limited, such as for very young or old lives.
Adjustments are also made to mortality tables to provide a margin of
financial safety in insurance contracts and are considered sound practice
in the insurance industry.

Mortality tables used for the FEGLI program have been developed internally
by OPM actuaries based on the demographic composition of the federal
civilian workforce and the historic mortality rates of insured employees.
According to the OPM actuaries, this is done because the characteristics of
the federal civilian workforce appear to be different from the population at
large. OPM has constructed separate mortality tables for male and female
employees, active employees, retired employees, and disabled persons.
For SDVI, VA is required to use the Commissioners 1941 Standard Ordinary
Table of Mortality. For VMLI, VA is directed by law to use mortality data
appropriate to cover only the cost of insuring nondisabled lives.

An estimate of the expected cost of future insurance benefits can be
derived based on the expected rates of death, assumed rate of interest, and
policy benefits. This information is used by insurance companies to
establish premium rates such that the present value of the future
premiums less operating expenses equals the present value of future
benefits. If the present value of future benefits exceeds the present value
of future premiums plus any previously accumulated premiums held in
reserve, the program would have an unfunded liability. As such, mortality
tables and interest rate assumptions are generally fairly conservative to
ensure sufficient resources to pay future benefits. In the SDVI and VMLI
programs, the Congress has chosen to subsidize the premiums of disabled
veterans through the use of mortality assumptions for nondisabled
individuals. Premiums collected are not sufficient to cover expected future
benefits and an unfunded liability exists.




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                                 Appendix IV
                                 Other Insurance Programs




Implementation
Considerations for Life
Insurance Programs
Adequacy of Current Budget   •   Increases in life insurance obligations due to program changes or growth
Reporting                        are not reflected in the year in which they occur since cash payments may
                                 not be required for many years.
                             •   Program income is not matched with program expenses. Premium and
                                 investment income necessary to pay future claims is recorded in the
                                 budget as negative outlays (income), while the future expense is not
                                 recorded. As a result, the relative cost of the program may be understated
                                 and sufficient funds may not be available to pay future claims.

Issues in Implementing an    •   Although methodology for estimating the risk-assumed cost of extending
Accrual-Based Budgeting          life insurance is well established in actuarial science, estimates are highly
Approach                         sensitive to assumptions such as interest rates.


                                 Budget Account: National Flood Insurance Fund
National Flood                                    (58-4236-0-3-453)
Insurance Program
                                 Agency: Federal Emergency Management Agency (FEMA)

                                 Bureau: Federal Insurance Administration (FIA)


Purpose                          The National Flood Insurance Program (NFIP) was established by the
                                 National Flood Insurance Act of 1968 (Public Law 90-448) to (1) identify
                                 flood prone areas, (2) make flood insurance available to property owners
                                 living in communities that joined the program, (3) encourage floodplain
                                 management efforts to mitigate flood hazards, and (4) reduce federal
                                 spending on disaster assistance. Some of the key factors leading to the
                                 program’s establishment were the reluctance of private insurers to sell
                                 flood coverage, increasing losses caused by floods because of floodplain
                                 encroachment, and higher federal expenditures for relief and flood
                                 control.5 Since its establishment, NFIP has been expanded and modified
                                 several times.




                                 5
                                 Federal Disaster Assistance, Bipartisan Task Force on Funding Disaster Relief, S. Doc. No. 4, 104th
                                 Cong., 1st Sess. (1995).



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Coverage                   Federal flood insurance is available in the 50 states, the Virgin Islands,
                           Puerto Rico, Guam, the District of Columbia, and American Samoa. In
                           fiscal year 1995, NFIP had about 3.3 million policies, totaling over
                           $325 billion, in force in over 18,000 communities nationwide. As of
                           January 1997, there was approximately $380 billion of insurance in force.

                           NFIP has two principal components: emergency and regular. The
                           emergency program is available in communities before detailed mapping6
                           is completed. Under the emergency program, structures identified in
                           flood-prone areas are eligible for limited amounts of coverage at
                           subsidized rates. However, according to FIA, flood insurance rate maps
                           (FIRMs) have been completed for nearly all communities considered to be
                           flood-prone, and only a very few communities remain in the emergency
                           program.

                           After mapping is completed, the communities enter the regular program.
                           Under the regular program, there are basically two classifications of
                           properties (1) pre-FIRM properties—those built before the initial mapping
                           studies were completed and (2) post-FIRM properties—those built after the
                           mapping studies were completed. After a community joins the regular
                           program, the rates for the pre-FIRM properties may still be subsidized, but
                           post-FIRM properties are to be charged actuarially-based rates. In fiscal
                           year 1996, subsidized policies accounted for approximately 38 percent of
                           the total policies in force. Under the regular program, coverage is available
                           for virtually all types of buildings and their contents with coverage limits
                           of up to $350,000 for residential properties and $1 million for other
                           properties.


Eligibility Requirements   To be eligible for federal insurance, communities must adopt and enforce
                           floodplain management ordinances that meet or exceed the minimum
                           standards of the program. Communities must join the program within
                           1 year of the time they are identified as flood-prone.

                           The purchase of flood insurance was voluntary until the adoption of the
                           Flood Disaster Protection Act of 1973. The 1973 Act required the purchase
                           of flood insurance to cover structures in special flood hazard areas of
                           communities participating in the program if (1) any federal loans or grants
                           were used to acquire or build the structures and (2) loans were secured by
                           improved properties and the loans were made by lending institutions that

                           6
                            Flood insurance rate maps (FIRMs) provide information such as elevation and flood zone that are
                           necessary for classifying properties according to flood risk.



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                    are regulated or insured by the federal government. In 1994, the Congress
                    amended NFIP to, among other things (1) prohibit federal disaster relief in
                    flood disaster areas to persons who failed to obtain and maintain required
                    flood insurance and (2) establish civil monetary penalties for regulated
                    lenders who fail to ensure that their borrowers obtain required flood
                    insurance.


Program Financing   The program is financed primarily through premiums, fees, and interest
                    income. As noted above, owners of post-FIRM structures pay
                    actuarially-based rates. By contrast, subsidized rates are available for
                    owners of older, generally less flood-worthy, pre-FIRM structures. FIA is
                    authorized to borrow up to $500 million from the Treasury without
                    approval of the President and up to $1 billion with approval of the
                    President.7 In addition, the Congress has appropriated funds for NFIP from
                    time to time over the program’s history. The program has not received a
                    general fund appropriation since 1986.

                    By design, NFIP is not actuarially sound. The Congress authorized FIA to
                    subsidize a significant portion of the total policies in force but did not
                    provide annual appropriations to cover the implicit subsidy costs.
                    Although the program has achieved a goal of becoming self-supporting for
                    the average historical loss year,8 it may not have sufficient resources to
                    meet potential catastrophic losses.9 This is the case because the historical
                    experience period used does not include any loss years considered to be
                    of a catastrophic level.10

                    Figure IV.3 shows the program’s premium income and loss and loss
                    adjustment expenses since the program’s inception. The volatility in the
                    program experience demonstrates the uncertainty surrounding the
                    average loss and loss adjustment costs.

                    7
                     FIA’s borrowing authority was increased to $1.5 billion for fiscal year 1997 only.
                    8
                     Premium rates for NFIP are established so that total premium revenue is sufficient to cover the
                    average historical loss year. According to FIA, the rate review typically first determines whether the
                    actuarial rates need to be adjusted. The effects of any such adjustments on maintaining the overall
                    target level are then projected. Should there be a shortfall, adjustments to policy coverage or
                    premiums for pre-FIRM policies will likely be proposed to make up the difference so that the
                    combination of actuarial and subsidized policies would be generating written premiums at least to the
                    level of NFIP’s self-supporting target.
                    9
                     Flood Insurance: Financial Resources May Not Be Sufficient to Meet Future Expected Losses
                    (GAO/RCED-94-80, March 21, 1994).
                    10
                      According to FIA, the probable maximum loss resulting in $4.5 billion to $5 billion in claim losses has
                    a 1 in 1,000 chance of occurring. For comparison purposes, Hurricane Hugo resulted in claims of
                    $0.4 billion.



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Figure IV.3: NFIP Premium Income
Versus Loss and Loss Adjustment    Nominal dollars in millions
Expenses, Fiscal Years 1969-1996
                                   1,200

                                   1,000


                                     800


                                     600


                                     400


                                     200


                                        0
                                            69    71     73      75    77     79    81   83       85   87   89       91   93   95
                                                                                    Fiscal year

                                                                 Premium revenues    Loss/loss adjustment expenses


                                   Source: FIA unaudited data.




                                   The program has had to borrow from the Treasury several times in recent
                                   years. For example, in fiscal year 1993, the nation experienced severe
                                   flood damage resulting in flood insurance claims more than double the
                                   historical average loss. As a result, the program borrowed and since repaid
                                   funds from the Treasury to pay excess claims. Similarly, in fiscal year
                                   1995, the program experienced losses that were much greater than the
                                   historical average loss. As a result, the program again exercised its
                                   borrowing authority. According to FIA, as of March 31, 1997, NFIP owed the
                                   Treasury $818 million.


Current Budget Treatment           The National Flood Insurance Fund, a revolving fund, was established to
                                   carry out NFIP. The program includes both mandatory and discretionary
                                   spending. Funding for expenses other than costs incurred in the
                                   adjustment and payment of claims is available only to the extent provided
                                   in appropriation acts. Figure IV.4 shows the program’s budgeted versus
                                   actual outlays from fiscal years 1973 through 1996.




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Figure IV.4: National Flood Insurance
Fund Budget Estimates Versus Actual
                                        Nominal dollars in millions
Outlays, Fiscal Years 1973-1996
                                        600



                                        400



                                        200



                                           0



                                        -200



                                        -400
                                               73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                               Fiscal year

                                                                            Budget   Actual




Risk Assessment Methods                 According to FIA, its actuarial rate-setting method for unsubsidized policies
                                        (post-FIRM) could be used to generate reasonable estimates of the costs of
                                        the long-term expected risk for the entire program. The difference
                                        between the costs of the long-term expected risk and the actual premium
                                        rates could be used to provide an estimate of the government’s subsidy
                                        costs.

                                        FIA uses a class-rating system to establish actuarial rates. That is, FIA
                                        classifies properties according to key characteristics of flood risk. All
                                        owners of properties in the same risk group are then charged the same
                                        rates. Even though individual risk may vary among properties within each
                                        risk group classification, these rates are actuarially-based in the sense that
                                        risk exposure for like properties is considered when setting the group’s
                                        rates.

                                        Information about the risk of flooding is essential to establishing
                                        actuarially sound rates. Two key characteristics that are used to classify
                                        properties according to flood risks include (1) the flood zone and (2) the




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elevation of the structure relative to the base flood elevation (BFE).11
Information about flood zones and BFEs is obtained from FIRMs.

The basic method for establishing actuarial rates on post-FIRM structures
lying within the 100-year floodplain follows the hydrologic model
described in a 1966 Department of Housing and Urban Development (HUD)
report, Insurance and Other Programs for Financial Assistance to Flood
Victims.12 The basic logic of the model is to set rates for a property
according to its risk of being flooded. According to an FIA actuary, the
model is basically an expected value calculation based on measures of the
frequency and severity of floods.13

Thus, a key data element is an estimate of the probabilities that floods of
different severities, relative to BFE, will occur in a given year. FIA calls
these data probability of elevation (PELV) values. Although within any zone
there is a 1-percent chance that flood waters will exceed the BFE, the
degree to which flood waters will reach above or below that level will vary
across zones. PELV tables provide detailed information, by zone, about the
frequency with which floods of all possible water surface elevations can
be expected to occur. These data were generated on the basis of detailed
engineering studies, available flood insurance data, simulations, and
professional judgments and were established for each flood-hazard zone to
meet generally accepted scientific parameters and legal considerations.14

Another key data element is the structural damage that will be suffered
when a flood occurs. For a variety of depths of floods, and the associated
depth of water in a structure, FIA has data that provide estimates of the
percent of the value of a structure that is expected to be damaged. FIA calls
these data the depth-percent-damage relationship or the damage by
elevation (DELV) values. Information is presented by 1-foot increments of
flood level within the structure and expressed as the average percentage

11
  BFE is the elevation relative to mean sea level at which there is a 1-percent chance of flood waters
exceeding that level in a given year. The level of BFE within a community can change throughout the
floodplain. These changes are delineated on FIRMs.
12
 Rates for post-FIRM properties that are outside the 100-year floodplain are set primarily through an
analysis of previous years’ claims.
13
 The HUD report describes the “hydrologic method” of rate-making as a method which “uses available
data on the occurrence of floods and damage, but is considerably more sophisticated than merely
averaging losses over a period of time.”
14
  As noted in GAO/RCED-94-80, March 21, 1994, one of the problems in originally establishing the
PELV tables was that the flood histories on which these studies were based were generally not very
long. Statistical literature has shown that this may cause a bias toward establishing frequency
probabilities that are too low. Consequently, the original PELV values have been modified to account
for this bias.



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    of the property’s value that will be damaged due to a flood of that
    elevation. For example, according to 1987 DELV information, a one-story,
    no basement structure located in the AE zone would sustain damage equal
    to 21 percent of the property’s value if flood water reached a depth of 2
    feet. As with the PELV data, information used in establishing DELV values
    was obtained primarily from engineering studies. In 1973, data for DELVs
    were selected on the basis of studies done by the U.S. Army Corps of
    Engineers and available flood claims at the time. According to FIA, DELVs
    are compared to actual experience and updated when sufficient data
    exist.15

    Knowledge of the elevation-frequency relationship and the depth-damage
    allows a summation of the range of flood probabilities and their associated
    damage to property and contents. Each possible flood is multiplied by the
    expected damage should such a flood occur, and then each of these is
    added together. The total of each possible flood’s damage provides an
    expected per annum percent of the value of property damage due to
    flooding. This expected damage can then be converted to an expected loss
    per $100 of property value covered by insurance. This per annum expected
    loss provides the fundamental component of rate-setting.

    Several other factors important for modifying expected losses or for
    building additional expense items into the rates are also considered. These
    variables include the following:

•   Loss adjustment factor: Rates are “loaded” or adjusted upward to account
    for costs associated with claims and loss adjustments.
•   Deductible offset factor: Rates are adjusted downward to take into
    account that some portion of each claim will not be covered because of
    the policy deductible.
•   Underinsurance factor: Rates are adjusted to take into account that the full
    value of the property may not be insured.
•   Expense items factor: Rates are loaded for certain expenses, such as
    agents’ commissions.




    15
      FIA determines whether it has sufficient data on actual floods of different severities since 1978 to
    replace the original DELV. If data are sufficient then there is “full credibility” and the original DELVs
    are replaced. If insufficient claims data exist for full credibility, DELVs are based on a weighted
    average of the original base table values and the actual experience since 1978, where the weighting is
    determined by the ratio of actual experience claims to the number of experience claims necessary for
    full credibility. This would mean that over time the original, theoretical DELV will have less weight in
    determining actual DELV used for rate-setting.



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Implementation
Considerations for the
National Flood Insurance
Program
Adequacy of Current Budget   •   The current cash-based budget does not recognize or fund the subsidy cost
Reporting                        implicit in the government’s flood insurance commitment for losses in
                                 excess of the historical loss year. As a result, the relative budgetary cost of
                                 the program may be understated and the program may not have sufficient
                                 funds to cover future claims. FIA estimates the annual “missing
                                 premium”—the government’s subsidy—at about $520 million.
                             •   The sporadic nature of floods may cause fluctuations in the deficit
                                 unrelated to the budget’s long-term structural balance.

Issues in Implementing an    •   Although FIA’s risk assessment experience and established rate-setting
Accrual-Based Budgeting          methodology will provide a useful foundation for generating risk-assumed
Approach                         estimates, some additional work may be required to adapt these estimates
                                 for use in an accrual-based budget.
                             •   The appropriate level of reserves and the basis for reestimation will have
                                 to be determined. FIA has done some work developing estimates of
                                 catastrophic reserve levels but additional refinements and modifications
                                 will likely be required.
                             •   The appropriate basis for accrual cost measurement—the average
                                 historical loss year or the program’s long-term expected loss (including
                                 rare catastrophic loss years)—will have to be determined.
                             •   FIA officials and staff expressed concern about the amount of staff
                                 resources required to update and adapt estimates and to comply with the
                                 requirements of an accrual-based budgeting approach.


                                 Budget Account: Federal Crop Insurance Corporation Fund
Federal Crop                                      (12-4085-0-3-351)
Insurance Program
                                 Agency: Department of Agriculture (USDA)

                                 Bureau: Risk Management Agency (RMA)16




                                 16
                                  The Federal Crop Insurance program is administrated by the Federal Crop Insurance Corporation
                                 (FCIC), a wholly owned government corporation. The 1996 Farm Bill established the Risk Management
                                 Agency within USDA and it has jurisdiction over FCIC.



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Purpose    The Federal Crop Insurance program was established in 1938 by the
           Federal Crop Insurance Act17 to protect crop farmers from unavoidable
           risks associated with adverse weather, plant diseases, and insect
           infestations. The program has been amended numerous times during its
           history. Extensive amendments were adopted in the Federal Crop
           Insurance Act of 198018 (Public Law 96-365) and the Federal Crop
           Insurance Reform Act of 199419 (Title I of Public Law 103-354). Most
           recently, several changes were made to the program by provisions of the
           Federal Agricultural Improvement and Reform Act of 1996 (Public Law
           104-127, the Farm Bill).


Coverage   Crop insurance is available in all 50 states and Puerto Rico. In crop year
           1996, there was about $27 billion of insurance in force written in over
           3,000 counties. These policies provided coverage for approximately
           200 million acres.

           Under the changes made by the Federal Crop Insurance Act of 1994, two
           types of coverage—catastrophic and additional—are available for most
           major crops. Catastrophic coverage provides producers a minimum level
           of protection for a small processing fee. This coverage compensates
           farmers for crop yield losses greater than 50 percent at a payment rate of
           60 percent of the expected market price. Premiums for this coverage are
           fully subsidized by the government.

           Farmers can also purchase additional coverage from participating private
           insurance companies.20 Farmers who purchase this additional insurance
           must choose both the coverage level (the proportion of the crop to be
           insured) and the unit price (e.g., per bushel) at which any loss is
           calculated. Farmers can choose to insure as much as 75 percent of normal
           production or as little as 50 percent of normal production at different price




           17
             Title V of the Agricultural Adjustment Act of 1938 (Public Law 75-430, 7 U.S.C., 1501-1520).
           18
            The Federal Crop Insurance Act of 1980 authorized FCIC to expand coverage to include all
           agricultural crops in all agricultural counties and to subsidize producer premiums.
           19
            Among other things, the 1994 Act repealed ad hoc disaster authority and authorized FCIC to offer
           catastrophic risk protection.
           20
             According to FCIC, additional coverage can be made available through USDA if private insurance
           providers do not service an area. The 1996 Farm Bill allows USDA to continue offering catastrophic
           risk protection through its local offices but only in states where there are too few approved private
           insurance providers.



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                           levels.21 With respect to unit price, farmers can choose to value their
                           production at USDA’s full price or a percentage of the full price. The
                           government pays part of the farmer’s premium for this additional
                           coverage.

                           The Crop Insurance Reform Act of 1994 also created a new program, the
                           Noninsured Assistance Program (NAP), for producers of most crops not
                           currently covered by the crop insurance program. For a farmer to become
                           eligible for payment, area-wide losses must be at least 35 percent of
                           normal yields and the farmer must experience an individual minimum loss
                           of at least 50 percent. Coverage levels are similar to those under the
                           catastrophic coverage level once the trigger is activated.


Eligibility Requirements   The 1996 Farm Bill eliminated mandatory participation22 in the federal
                           crop insurance program to qualify for assistance under other farm
                           programs. This applies to farmers who provide a written waiver to the
                           Secretary of Agriculture agreeing to forgo eligibility for disaster payments
                           in connection with a crop.23 If a farmer does not sign a waiver,
                           catastrophic coverage is required for receipt of a Conservation Reserve
                           Program (CRP) payment, a USDA loan, or the 7-year market transition
                           payment for eligible wheat, feed grain, cotton, or rice growers.


Program Financing          The crop insurance program is financed primarily through general fund
                           appropriations and farmer-paid premiums. FCIC is authorized under the
                           Federal Crop Insurance Act, as amended, to use funds from the issuance
                           of capital stock which provides working capital for FCIC.24 FCIC does not
                           earn interest on cash maintained in U.S. Treasury accounts.

                           Under the Federal Crop Insurance Reform Act of 1994, FCIC is required to
                           set insurance premiums at rates that are actuarially sufficient to attain an
                           expected loss ratio25 of not greater than 1.1 through September 1998, and

                           21
                            According to FCIC, the 1994 Act authorizes 85-percent coverage. This coverage may be implemented
                           on a limited basis in 1997.
                           22
                             The Federal Crop Insurance Act of 1994 required producers to obtain at least the catastrophic level of
                           insurance to be eligible for benefits under the price support or production adjustment program, the
                           conservation reserve program, or farm credit programs.
                           23
                             Effective for spring planted 1996 crops and all subsequent crops.
                           24
                            The act authorizes capital stock of $500 million subscribed by the United States. There has been no
                           change in the level of capital stock issued since August 1985.
                           25
                             The loss ratio represents insurance claims expense divided by premium revenues.



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not greater than 1.075 thereafter. In addition to the premiums paid by
producers, FCIC receives a mandatory indefinite appropriation to the
Insurance Fund to provide funds for the program’s premium subsidy costs,
excess losses, and delivery expenses. For fiscal year 1996, net insurance
premium revenue from farmers was approximately $600 million and the
appropriation for the government’s premium subsidy was approximately
$990 million. Total appropriations received to cover operating costs in
fiscal year 1996 were approximately $1.6 billion. In addition, farmers are
required to pay an administrative fee.26

The program has a history of financial losses.27 For example, since the
program was expanded, it has paid out approximately $3.4 billion more in
claims than it has received premiums from farmers and the federal
government between crop years 1980 and 1996. Since losses in excess of
premium income are a cost to the government, they represent additional
federal subsidies. Figure IV.5 shows the total premiums—both producer
and government—and claim payments from fiscal years 1980 through
1996.




26
  Producers are required to pay a $50 processing fee per covered crop per county upon enrollment in
the program for catastrophic and limited additional coverage up to 65 percent of production at full
price. The total fees cannot exceed $200 per producer per county, up to a maximum of $600 per
producer for all counties in which a producer has insured crops. According to FCIC, the fee for
additional coverage greater than 65 percent of production at full price is $10 per crop per county
without limitation. USDA can waive processing fees for financial hardship cases.
27
 See Crop Insurance: Additional Actions Could Further Improve Program’s Financial Condition
(GAO/RCED-95-269, September 28, 1995).



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Figure IV.5: Federal Crop Insurance
Premiums Versus Loss and Loss
Adjustments, Fiscal Years 1980-1996   Nominal dollars in millions
                                      2,000




                                      1,500




                                      1,000




                                           500




                                             0
                                                 80   81   82   83   84   85     86   87   88    89    90   91   92   93   94   95   96
                                                                                       Fiscal year

                                                                                 Premiums     Losses


                                      Source: USDA.




Current Budget Treatment              Budget reporting for the Federal Crop Insurance program has undergone
                                      several changes in recent years.28 Under the most recent changes included
                                      in the 1996 Farm Bill, the expenses of the Federal Crop Insurance program
                                      will be handled in two budget accounts. Beginning in fiscal year 1998, the
                                      Federal Crop Insurance Fund will handle insurance premiums, the
                                      government’s premium subsidy, claim losses, and a portion of the
                                      program’s insurance sales and claims processing administrative costs.
                                      These costs will be covered by a mandatory indefinite appropriation.29
                                      Salaries, general governmental administrative costs, and agent
                                      commissions will be handled in a separate administrative and operating


                                      28
                                        Both the Federal Crop Insurance Reform Act of 1994 and the Federal Agricultural Improvement and
                                      Reform Act of 1996 (the Farm Bill) made changes in the budget reporting for the Federal Crop
                                      Insurance program. Prior to the 1994 reforms, FCIC maintained two funds: (1) the Crop Insurance
                                      Fund—primarily for insurance premiums and claim losses and (2) a separate administrative and
                                      operating account which handled salary and general administrative expenses as well as insurance sale
                                      and claim processing costs. Under the 1994 reforms, FCIC’s salary and general administrative
                                      expenses were shifted to the Farm Service Administration’s administrative and operating account.
                                      Claim losses and all other program expenses were handled in the Crop Insurance Fund.
                                      29
                                       In the past, FCIC relied on Commodity Credit Corporation (CCC) funding for losses that exceeded
                                      premiums. Although this authority to use CCC funding still exists, FCIC is also authorized to draw
                                      necessary funds directly from the Treasury.



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                                   account of the newly established RMA. These costs will be classified as
                                   discretionary.

                                   Figure IV.6 shows the budget estimates versus actual outlays for the
                                   Federal Crop Insurance Corporation Fund from fiscal years 1973 through
                                   1996. This figure shows both that budget estimates are usually lower than
                                   actual outlays and the sometimes erratic nature of actual outlays.


Figure IV.6: FCIC Fund Budget
Estimates Versus Actual Outlays,
                                   Nominal dollars in millions
Fiscal Years 1973-1996
                                   2,000



                                   1,500



                                   1,000



                                    500



                                       0



                                    -500
                                           73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                          Fiscal year

                                                                       Budget   Actual




Risk Assessment Methods            FCIC has an established rate-setting methodology which, according to
                                   agency officials, could serve as the foundation for estimating the risk
                                   assumed by the government for the crop insurance program. For example,
                                   the difference between the “pure” or “full-risk” premium and actual
                                   premium rates could be used to provide an estimate of the government’s
                                   subsidy costs for policies issued in a given year. However, as discussed in
                                   chapter 5, the rate-setting methodology is complex because the risk of
                                   growing a particular crop varies by county, farm, and farmer. Because of
                                   all the possible combinations involved, hundreds of thousands of rates are
                                   in place. Thus, a number of implementation issues would have to be




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resolved. The following discussion provides a brief overview of the
premium rate-setting process.30

Each year, FCIC follows a multistep process to establish rates for each crop
included in the program. The process involves establishing base rates for
each county crop combination and adjusting these basic rates for a
number of factors, such as coverage and production levels. In addition,
rates are adjusted to account for the legislated limitations in price
increases.

For each crop, FCIC begins the process by extracting data on counties’ crop
experiences for all years available (up to 20) from its historical database.
The data elements for each crop, crop year, and county include (1) the
dollar amount of the insurance in force (coverage sold), (2) the dollar
amount of the claims paid (indemnities), and (3) the average coverage
level. Data for farmers who incur frequent and severe losses relative to
other farmers are removed from the resulting database to avoid setting
rates that are higher than necessary for the risk represented by the farmers
who are not considered high risk. The premium rates for high-risk
producers are established separately under the high-risk program.

The historical data are then adjusted to the 65-percent coverage level.
Using the adjusted data, FCIC computes the loss-cost ratio for each crop in
each county. The loss-cost ratio is calculated by dividing the total claim
payments by the total insurance in force; the result is stated as a
percentage.31 The loss-cost ratios are calculated using the latest available
data, which are for the period ending 2 years before the year for which the
rates are being established. For example, the crop year 1995 rates were
established in 1994 at which time the most recent 20-year record was for
crop years 1974 through 1993.

A loss-cost ratio is calculated for each of the 20 years and then these data
are divided into two segments—the 4 years with the highest loss-cost
ratios and the 16 years with the lowest loss-cost ratios.32 For the 4 years

30
 The rate-setting for the crop insurance program is discussed in Crop Insurance: Additional Actions
Could Further Improve Program’s Financial Condition (GAO/RCED-95-269, September 28, 1995).
31
  For example, if the claims paid in 1 year totaled $7.36 and the insurance in force was $100, the
loss-cost ratio is 7.36 percent. The percentage represents the rate that would need to be charged per
$100 of insurance coverage if total premiums are to equal the total claim payments for that year. In this
example, the 7.36 percent indicates that a rate of $7.36 was required per $100 of insurance coverage
sold.
32
 According to FCIC’s senior actuary, the procedures described herein will be modified beginning with
1998 crops to incorporate the results of an analysis conducted by an actuarial firm and USDA.



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with the highest loss-cost ratios, the ratios are capped at the loss-cost ratio
for the highest loss year in the 16-year segment. To establish the county
unloaded rate, the average for all 20 years is calculated, using the capped
loss-cost ratios for each of the 4 years. Thus, the 20-year average loss-cost
ratio consists of actual loss-cost ratios for the 16 lowest loss years and the
capped loss-cost ratios for the 4 highest loss years.33

The county unloaded rates are then adjusted to minimize the differences in
rates among counties using a weighting process. A surcharge for
catastrophic coverage for each crop in each state is then developed and
added to the adjusted unloaded rate for each county in the state.34 The
result of this process is a basic rate for the county for the 65-percent
coverage level and the average production level in that county.35

Next, the rates at the 65-percent coverage level are adjusted for each
farming practice, such as whether the insured acreage is irrigated or
dryland, and for each crop type, such as winter or spring wheat, using
factors based on historical data. Field underwriters review the rates36 for
reasonableness on the basis of their knowledge and continuing research
on farmers’ experiences with the particular crop in the county and the
surrounding area and recommend changes when they believe they are
warranted. On the basis of these recommendations, FCIC analysts make
adjustments.

Following this review and any resulting adjustments, rates are adjusted
upward for the risk represented when farmers choose to subdivide their
farming operation for a given crop into multiple units for crop insurance
purposes. According to FCIC, this is done because USDA’s historical data

33
  The excess of losses above the capped amount is pooled at the state level and reallocated to the
counties. According to FCIC, this procedure is intended to reduce the variation of rates from one year
to the next.
34
  The surcharge is established by pooling the amount of insurance in force and the claim payments for
the 4 years with the highest loss-cost ratios in each county that were not factored into the county
unloaded rates at the state level. These data are used to calculate a statewide surcharge for
catastrophic coverage (pooled claims payments divided by pooled insurance in force). If the pooled
losses at the state level exceed five points, the excess is returned to the counties and included in the
county unloaded rate.
35
  Rates for the 50-percent and 75-percent coverage levels are also established by applying factors of
0.72 and 1.54 to the rates established for the 65-percent coverage level.
36
  Because the regional service office underwriters are more familiar with the 75-percent coverage
level, the basic rates are adjusted to the 75-percent level to facilitate review. According to FCIC, in the
1980s, when much of the crop insurance business was at the 75-percent coverage level, rates were
calculated on that basis. Today, although most business is at the 65-percent level and rates are
calculated on that basis, many underwriters remain more comfortable performing comparisons at the
75-percent level.



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                                 show that farming operations insured on a multiple unit basis are more
                                 likely to make claims than those insured as one unit.

                                 As noted above, the calculated rates are for farmers whose historic
                                 production level (yield) is about equal to the average for all producers in
                                 the county. However, many farmers’ average production levels are above
                                 or below the county’s average. According to USDA, farmers’ chances of
                                 having a loss decreases as production increases. Therefore, rates are
                                 adjusted using a mathematical model to account for production levels that
                                 differ from the average production level.

                                 The calculated full rates are reduced as needed to ensure that they do not
                                 exceed the maximum 20-percent increase per year allowed by law. As a
                                 final step, discounts are developed for farmers who buy hail and fire
                                 protection from private insurance companies.37


Implementation
Considerations for the
Federal Crop Insurance
Program
Adequacy of Current Budget       Since the costs associated with a normal loss year are included in the
Reporting                        budget year estimates for the crop insurance program, policymakers
                                 receive some signals about the program’s potential costs at the time
                                 decisions are made. However:

                             •   On a cash basis, the program sustained significant losses without
                                 prompting recognition of funding deficiencies until claims had occurred.
                                 Between crop years 1980 and 1996, the program’s claims exceeded
                                 premiums by approximately $3.4 billion.
                             •   The need and cost of establishing reserves over time is not explicitly
                                 recognized in outlays or in the deficit in the year the insurance is
                                 extended.
                             •   The sporadic nature of crop losses will cause fluctuations in the deficit
                                 unrelated to the budget’s long-term structural balance.




                                 37
                                  By law, this option is only offered to farmers who purchase at or above the 65-percent and full-price
                                 coverage.



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Issues in Implementing an   •   Although FCIC’s risk assessment experience and established rate-setting
Accrual-Based Budgeting         methodology will provide a foundation for generating risk-assumed
Approach                        estimates, additional work will be required to determine how to adapt
                                these estimates for accrual-based budgeting purposes.
                            •   Due to the complexity of the risk assessment process and the timing
                                differences between the detailed rate-setting process and the budget cycle,
                                a number of implementation challenges will have to be resolved. For
                                example, an appropriate and feasible aggregation level for risk factors will
                                have to be determined.
                            •   Additional work would be required to determine the basis for reestimation
                                and reserve levels.


                                Budget Account: Noncredit Account
Political Risk                                   (71-4184-0-3-151)
Insurance
                                Agency: Overseas Private Investment Corporation (OPIC)


Purpose                         The Overseas Private Investment Corporation (OPIC), which began
                                operations in 1971, was established to facilitate U.S. private investment in
                                developing countries and countries with emerging markets. OPIC’s
                                insurance programs reduce the risk of U.S. private investment in these
                                countries by offering protection against several political risks. All valid
                                claims arising from OPIC’s investment insurance are explicitly backed by
                                the full faith and credit of the United States. In general, the coverage
                                offered by OPIC is more comprehensive—both in scope and duration—than
                                that currently available from private sector insurers.

                                OPIC operates as a self-financing governmental agency. In addition to its
                                insurance activities, OPIC provides project financing and makes equity
                                capital available by guaranteeing long-term loans to private equity
                                investment funds.


Coverage                        OPIC   insures against three types of political risks:

                            •   Currency inconvertibility: The deterioration of an investor’s ability to
                                convert and transfer profits, debt service, and similar remittances related
                                to insured investments from local currency to U.S. dollars due to new
                                currency restrictions. OPIC does not protect against currency devaluation.




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•   Expropriation: The loss of investment due to nationalization, confiscation,
    or expropriation by a foreign government including “creeping”
    expropriation—government actions that deprive an investor of
    fundamental rights in a project for a period of at least 6 months. Losses
    due to lawful regulatory or revenue actions by host governments as well as
    actions deemed to be provoked by the investor or foreign enterprise are
    excluded.
•   Political violence: The loss of assets or income due to war, revolution,
    insurrection, or politically motivated civil strife, terrorism, and sabotage.
    Actions, such as strikes, undertaken primarily to achieve labor or student
    objectives are not covered.

    In addition to these three areas, OPIC has specialized insurance programs
    for financial institutions, leasing arrangements, natural resource projects,
    oil and gas projects, and contractors and exporters. With limited
    exception, OPIC’s insurance policies cover a maximum of 90 percent of an
    eligible investment. Policy terms can extend up to 20 years38 and are
    generally only cancelable by OPIC in the event of default.

    OPIC operates in approximately 140 counties, including countries in central
    and eastern Europe. OPIC’s outstanding exposure as of September 30, 1996,
    totaled $13.4 billion. This exposure is governed by OPIC’s statutory
    limitation and represents the amount for which OPIC is contingently liable.
    An adjustment of outstanding exposure for standby coverage, for which
    OPIC is committed but not currently at risk, yields OPIC’s reported Current
    Exposure to Claims (CEC), which was $6.4 billion for fiscal year 1996. The
    face value of aggregate insurance outstanding at the end of fiscal year 1996
    was $31.4 billion. This represents the sum of all current and standby
    coverage elected by investors.

    OPIC’sinsurance exposure has grown significantly in recent years. Between
    1990 and 1996, OPIC’s CEC almost doubled from $3.3 billion to $6.4 billion.
    About 45 percent of this 6-year increase occurred in fiscal year 1995.
    Demand for OPIC’s insurance is expected to continue to grow due to
    expanding international investment opportunities. The projected face
    value of insurance outstanding at the end of fiscal year 1997 is
    $33.7 billion.




    38
     The insurance term for loans, leases, and transactions is generally equal to the duration of the
    underlying contract or agreement.



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Eligibility Requirements   OPIC’s political risk insurance is available to U.S. investors, contractors,
                           exporters, and financial institutions involved in international transactions.
                           Specifically, OPIC’s insurance program covers U.S. citizens, U.S. companies
                           that are more than 50 percent owned by U.S. citizens, foreign corporations
                           that are at least 95 percent U.S.-owned, and other foreign entities that are
                           100 percent U.S.-owned. OPIC’s insurance coverage is available for new
                           investments or expansion of existing enterprises.

                           According to OPIC officials, they have discretion in determining the
                           insurability of projects and certain coverage may be unavailable or limited
                           due to underwriting or other reasons. For example, coverage amounts may
                           be limited for investments in countries where OPIC has a high portfolio
                           concentration and for highly sensitive projects.


Program Financing          OPIC’s income is derived primarily from (1) interest earnings on invested
                           assets, (2) premiums, (3) recoveries and (4) fees. In addition, OPIC has the
                           authority to borrow up to $100 million from the U.S. Treasury. Premium
                           rates for OPIC’s insurance are based on a standard pricing table for four
                           different sectors with adjustments made for project-specific risks. Actual
                           premiums may be increased or decreased, generally by up to one-third of
                           the base rate, depending upon an insured project’s risk profile.39

                           For fiscal year 1996, interest earnings on funds invested in U.S. Treasury
                           securities were OPIC’s largest source of revenue, accounting for 55 percent
                           of OPIC’s total revenue of $300 million. Insurance revenues—premiums
                           ($80.5 million) and miscellaneous income ($1.0 million)—accounted for
                           about 27 percent of OPIC’s total revenues. The majority of the remainder of
                           OPIC’s revenues stemmed from its investment financing activities.


                           As a whole, OPIC has been self-sustaining with positive net income in each
                           year since its inception. As shown in figure IV.7, since 1972 insurance
                           premium collections have exceeded claim payments in all but 3 years,
                           which were in OPIC’s early years of operation. As of September 30, 1996,
                           OPIC’s insurance program collected premium revenue totaling
                           $922.5 million, paid cash settlements of just over $288.8 million, and
                           collected cash recoveries of $277.9 million, resulting in total premium
                           income net of claims of $911.5 million. In addition to cash claim payments,
                           OPIC negotiated noncash settlements of approximately $227 million. At the




                           39
                            Actual premiums for natural resource projects and projects with investments of $50 million may vary
                           by more than one-third.



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                                      end of fiscal year 1996, OPIC had $1.8 billion in insurance loss reserves and
                                      retained earnings available for insurance losses.


Figure IV.7: OPIC Insurance Premium
Collections Versus Claim Payments,
Fiscal Years 1972-1996                Nominal dollars in millions
                                      100



                                       80



                                       60



                                       40



                                       20



                                           0
                                               72 73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                                Fiscal year

                                                                        Premiums     Cash claim payments

                                      Source: OPIC.




Current Budget Treatment              OPIC’s insurance activities are currently handled in one budget account, the
                                      “Noncredit Account,” a revolving fund that is a discretionary account
                                      under BEA. Although outlays are reported on a cash basis, OPIC uses accrual
                                      concepts to obligate funding for claim reserves.40 According to OPIC
                                      officials, this reserve is used to recognize losses that are probable and can
                                      be reasonably estimated in accordance with private sector accounting
                                      standards as required by the Government Corporation Control Act. When a
                                      claim occurs, cash payments are made from these reserves.


Risk Assessment Methods               The risk assessment methods used by OPIC to establish insurance reserves
                                      and set premium rates rely heavily on expert judgment and are not highly
                                      quantitative. According to OPIC officials, no standard actuarial model exists
                                      for quantifying political risks. Although OMB has suggested using options

                                      40
                                        To the extent that these reserves are a sufficient measure of the risk assumed, OPIC is already using
                                      the aggregate budget authority approach to accrual-based budgeting discussed in chapter 6.



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pricing or other econometric modeling approaches to assess the risk
assumed by OPIC’s insurance program, these models have not been
developed and some analysts we spoke with expressed concerns about
their cost-effectiveness and usefulness for this purpose.

In order to establish insurance reserves, OPIC analyzes, on a quarterly
basis, the losses inherent in the outstanding insurance portfolio. OPIC
officials told us that a general nonspecific reserve based on its entire
insurance portfolio is used because project-specific losses cannot be
reasonably estimated. Reserves are established in consultation with OPIC’s
external auditors and are based on OPIC management’s evaluation of
historical loss experience, the composition and volume of current
insurance commitments, and anticipated worldwide political and
economic conditions.

As a starting point, OPIC uses a calculation based on historical experience.
According to OPIC officials, the program’s entire historical experience is
used to determine reserve levels because claims have been sporadic over
the life of the program and no discernible pattern exists. An OPIC official
stressed that while this historical-based calculation provides a useful
starting point, management’s judgment is a key factor in determining the
appropriate reserve levels and additional adjustments are made to account
for OPIC’s new business and other factors that affect the level of risk
assumed.

OPIC also uses risk assessment to adjust rates from the standard pricing
tables for project-specific risk. In determining the risk associated with a
particular project, OPIC considers (1) project-specific risk, such as the
structure of the project and the experience of the project’s sponsors and
(2) country-based risk, such as projections of the country’s general
economic conditions, including balance of payments and foreign exchange
reserve levels. According to OPIC officials, the level of risk for each project
is assessed individually during the rate-setting process. However, OPIC
officials stressed that overall portfolio management is important in
controlling its overall risk exposure precisely because predicting political
risk for particular projects over long periods of time is so difficult.




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Implementation
Considerations for OPIC’s
Political Risk Insurance
Adequacy of Current Budget       OPIC’s multiyear, long-term contracts commit the federal government to
Reporting                        pay future claims for extended periods. As noted above, OPIC currently
                                 uses accrual concepts to obligate funding for claims inherent in insurance
                                 coverage outstanding. Thus, to the extent that these reserves represent the
                                 risk assumed by the federal government, OPIC’s current budgetary
                                 reporting is similar to the budget authority approach used for
                                 accrual-based budgeting outlined in this report. However, a number of
                                 limitations to this approach have been identified as follows:

                             •   Although budgetary reserves are obligated when they are realized, claim
                                 payments are not recognized in net outlays or the deficit until they come
                                 due. As a result, the future cost of new or growing commitments may not
                                 be isolated or fully recognized at the time they are extended.
                             •   OMB raised concerns that general reserves based on historical experience
                                 and management judgment may not fully focus attention on the risk
                                 assumed for new insurance commitments at the time they are extended.
                             •   As a result, changes in the composition and riskiness of OPIC’s insurance
                                 activities may not be fully recognized in the budget at the time the
                                 insurance is extended.


Issues in Implementing an    •   Estimates of political risk and future claims are uncertain due to their
Accrual-Based Budgeting          dependence on variables that are inherently difficult to predict, such as
Approach                         the political stability of governments and long-term economic conditions.
                             •   Risk assessment is complicated by (1) the individualistic nature of the risk
                                 covered, (2) the lack of relevant historical data, and (3) the constant
                                 volatility of the international political and economic environment.
                             •   The nature of OPIC’s insurance operations may not fit well with a credit
                                 reform model (an aggregate outlay approach using annual cohorts).
                                 • According to OPIC officials, estimating the net cost for a particular
                                   project would be complicated by (1) the uncertainties surrounding the
                                   magnitude and timing of loss recoveries and (2) the difficulty of
                                   allocating the benefits of overlapping contract provisions such as
                                   agreements that limit total losses for the same company.
                                 • OPIC insurance activities deal with a small number of diverse projects
                                   with individually negotiated terms and thus implementation challenges




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                           similar to those faced by international credit programs under the Credit
                           Reform Act are likely.
                     •   Based on their experience with credit reform, OPIC officials expressed
                         concerns that the additional reporting requirements to comply with an
                         aggregate outlay approach would divert staff resources from portfolio
                         management and loss recovery activities that are critical to mitigating total
                         losses.


                         The two federal war-risk insurance programs—aviation and
Federal War-Risk         maritime—provide insurance to commercial airlines and ship owners
Insurance Programs       during extraordinary circumstances, such as war and other hostilities, in
                         order to support the foreign policy interests of the United States. The
                         Aviation War-Risk Insurance program was established in 1951.41 The
                         War-Risk Insurance program for vessels was established under Title XII of
                         the Merchant Marine Act of 1936. Because of their similar purposes, these
                         programs would likely face common risk assessment and implementation
                         challenges under an accrual-based budgeting approach.


Aviation War-Risk        Budget Account: Aviation Insurance Revolving Fund
Insurance                                 (69-4120-0-3-402)

                         Department: Department of Transportation (DOT)

                         Bureau: Federal Aviation Administration (FAA)

Purpose                  The Aviation War-Risk Insurance program was established to insure
                         commercial aircraft that provide essential air service during extraordinary
                         circumstances—such as war and other hostilities—when such insurance is
                         not available commercially or is only available on unreasonable terms and
                         conditions.42

Coverage                 FAA issues both hull and liability war-risk insurance. Hull insurance covers
                         the aircraft itself. Liability insurance covers bodily injury to or the death of
                         the crew and passengers and the loss of or damage to cargo, property, and
                         people on the ground. The maximum amount of hull and liability coverage
                         provided under FAA’s war-risk insurance is limited to the amounts insured


                         41
                           49 U.S.C. § 44301 et. seq.
                         42
                          In November 1977, the Congress expanded FAA’s authority to provide all-risk insurance, but none
                         has been issued to date.



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                    by an airline’s commercial policy. The insured value of the hull cannot
                    exceed the fair and reasonable value of the aircraft.

                    FAA issues two forms of war-risk insurance: (1) nonpremium insurance,
                    which is provided at no cost to the airlines other than a one-time
                    registration fee and (2) premium insurance for which airlines pay a
                    risk-related premium. Generally speaking, FAA’s nonpremium insurance
                    covers flights performed directly for the government and premium
                    insurance covers other flights that are considered necessary to support the
                    foreign policy interests of the United States. According to FAA officials,
                    coverage under both types of insurance is issued sporadically and may
                    remain active for only limited durations.

                    FAA registers aircraft for nonpremium insurance when the carriers perform
                    contract services for federal agencies that have indemnification
                    agreements with DOT. Under the indemnification agreement, these federal
                    agencies reimburse FAA for the insurance claims they pay to the airlines.
                    Over 99 percent of all war-risk insurance issued has been nonpremium
                    insurance for flights sponsored by the Department of Defense (DOD).
                    According to FAA, the program has issued nonpremium coverage several
                    times since 1975.43

                    Premium insurance is only provided when the President makes a
                    determination that flights to a specific location are necessary to carry out
                    the foreign policy interest of the United States. Authority for this type of
                    insurance is provided for an initial period of 60 days, with an additional
                    60-day extension granted when it is considered necessary by the President.
                    According to FAA officials, premium policies have only been issued during
                    one period since 1975 when 36 premium policies were in force during the
                    Persian Gulf conflict. No premium policies have been issued since
                    March 1991.

Program Financing   The program is financed primarily through interest on Treasury securities,
                    insurance premiums for flights insured by premium insurance, and
                    registration fees for flights insured with nonpremium insurance. From its
                    inception through fiscal year 1996, the program’s revolving fund


                    43
                      According to FAA, the nonpremium aviation insurance has been activated since 1975 as follows: 50
                    flights to Honduras were covered between 1983 and 1984; approximately 5,000 flights into the Middle
                    East were covered from mid-1990 through mid-1991; one flight was covered from Oman to Frankfurt in
                    January 1991; 20 flights to Kuwait were covered from November 1992 to April 1993; 155 flights into
                    Somalia were covered between late 1992 and early 1994; three flights to Georgia were covered in early
                    1994; 32 flights to Haiti were covered between September 1994 and October 1994; and 111 flights to
                    Bosnia were covered between April 15 and September 30, 1996.



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                           accumulated approximately $67 million in revenues—including interest
                           earnings—and paid out net claims totaling only about $151,000.

                           Despite the fund’s positive position, the accumulated balance may be
                           insufficient to pay potential claims. For example, in 1994, we reported that
                           claims for the loss of one aircraft—such as a Boeing 747-400 which can
                           cost over $100 million—could liquidate the fund’s entire balance and still
                           leave a substantial portion of the claim unpaid.44 If claims exceed the fund
                           balance, FAA would have to seek a supplemental appropriation to cover
                           losses. These potential funding shortfalls would not only subject the
                           government to unexpected costs but, as we previously reported, may also
                           reduce the effectiveness of the program.45

Current Budget Treatment   The Aviation War-Risk Insurance program is handled in one account, the
                           Aviation Insurance Revolving Fund. Figure IV.8 shows the program’s
                           budgeted versus actual outlays from fiscal years 1973 through 1996.
                           Negative outlays mean that the program’s receipts exceeded its outlays.




                           44
                            See Aviation Insurance: Federal Insurance Program Needs Improvements to Ensure Success
                           (GAO/RCED-94-151, July 15, 1994).
                           45
                             GAO/RCED-94-151.



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Figure IV.8: Aviation Insurance Fund
Budget Estimates Versus Actual             Nominal dollars in thousands
Outlays, Fiscal Years 1973-1996             1,000


                                               0


                                           -1,000


                                           -2,000


                                           -3,000


                                           -4,000


                                           -5,000


                                           -6,000


                                           -7,000
                                                    73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                                   Fiscal year

                                                                                Budget   Actual




Maritime War-Risk                          Budget Account: War-Risk Insurance Revolving Fund
Insurance                                                   (69-4302-0-3-403)

                                           Department: Department of Transportation (DOT)

                                           Bureau: Maritime Administration (MARAD)

Purpose                                    The War-Risk Insurance program provides protection against loss or
                                           damage from marine war risks in order to provide for the availability of
                                           merchant vessels for national defense or to protect the continued flow of
                                           U.S. foreign commerce during periods when commercial insurance cannot
                                           be obtained on reasonable terms and conditions.

Coverage                                   Three types of war-risk insurance coverage are available: (1) interim
                                           binder, (2) section 1202, and (3) section 1205.

                                       •   Interim binder: Interim binder insurance is a standby emergency program
                                           which provides insurance coverage for 30 days for eligible vessels when
                                           their commercial war-risk insurance is terminated under automatic
                                           termination and cancellation clauses included in commercial policies.



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                               According to MARAD, commercial insurance automatically terminates upon
                               outbreak of war, declared or undeclared, among any of the five major
                               powers—the United States, United Kingdom, France, the Russian Republic
                               (formerly the Soviet Union), or The Peoples’ Republic of China. The binder
                               policy provides immediate coverage so that the covered vessels can
                               complete their voyages without interruption.
                           •   Section 1202: Under Section 1202, the Secretary, with the approval of the
                               President, can offer insurance and reinsurance against loss or damage
                               caused by war risks to commercial vessels when commercial coverage
                               cannot be obtained on reasonable terms and conditions. Premiums are
                               charged for this type of insurance.
                           •   Section 1205: Under Section 1205, any United States department or agency
                               may obtain from MARAD war risk insurance. Insurance is provided without
                               premiums in consideration of the insured agency’s agreement to indemnify
                               MARAD for all losses covered by such insurance.


Program Financing              As noted above, the financing mechanisms vary among the different types
                               of war-risk coverage. Under interim binder insurance, premiums are to be
                               established to cover losses. If the original premiums do not meet the
                               losses, then a retroactive premium is to be assessed to cover the losses
                               without limit. Therefore, under this agreement, the fund should be
                               self-supporting; however, MARAD officials noted that this financing
                               mechanism has never been tested. For section 1202 coverage, risk-related
                               premiums are charged. In this case, the government bears the full risk of
                               losses on policies it issues. Under section 1205, MARAD is reimbursed by the
                               insured agency or department for losses covered by such insurance; thus
                               the insured agency or department bears the risk. In addition, the program
                               earns interest on funds invested in Treasury securities.

                               At the end of fiscal year 1996, the War-Risk Insurance Revolving Fund had
                               a balance of approximately $26 million. However, despite this positive
                               balance, the fund may not have sufficient funds to cover potential claims
                               when the program is activated. According to a MARAD official, the values of
                               covered vessels generally range from approximately $2 million to
                               $50 million.

Current Budget Treatment       The War-Risk Insurance program is reported in the War-Risk Insurance
                               Revolving Fund. The account has permanent authority from offsetting
                               collections. Program costs are mandatory but administrative expenses are
                               discretionary. Figure IV.9 shows the program’s budgeted versus actual
                               outlays since 1973. Negative outlays mean that the program’s offsetting
                               collections exceeded its outlays.



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Figure IV.9: War-Risk Insurance
Revolving Fund Budget Estimates
Versus Actual Outlays, Fiscal Years   Nominal dollars in thousands

1973-1996                                 0



                                       -500



                                      -1,000



                                      -1,500



                                      -2,000



                                      -2,500
                                               73 74 75 76 77 78 79 80 81 82 83 84 85 86 87 88 89 90 91 92 93 94 95 96
                                                                              Fiscal year

                                                                           Budget   Actual



Risk Assessment for the               The unique role of the maritime and aviation war-risk insurance programs
War-Risk Programs                     complicates risk assessment. As noted above, the war-risk insurance
                                      programs provide insurance to commercial airlines and ship owners
                                      during extraordinary circumstances, such as war and other hostilities, in
                                      order to protect the interests of the United States. Both programs provide
                                      coverage only when commercial insurance is not available or is available
                                      only on unreasonable terms. This unique role complicates risk assessment
                                      because (1) the insured risks tend to be case-specific and highly variable,
                                      (2) historical program data are limited and (3) commercial sector war-risk
                                      insurance data are unlikely to be directly applicable to the risk assumed by
                                      these federal programs. Currently, risk assessment for both programs
                                      relies heavily on expert judgment. Neither program uses quantitative
                                      modeling or standard risk assessment procedures.

                                      The risks assumed by the federal war-risk insurance programs tend to be
                                      case-specific and highly variable. MARAD officials stressed that each
                                      conflict is different and involves numerous factors. FAA officials told us
                                      that at the point commercial sector insurers leave the market—and federal
                                      war-risk insurance is activated—the calculation of risk becomes very
                                      difficult and subjective. According to FAA officials, it is not practical to




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Other Insurance Programs




develop a mathematical formula to calculate appropriate premium rates
due to the uniqueness of each case.

Officials from both agencies noted that the level of risk assumed by the
government can also be highly variable. Coverage may remain active only
for short durations such as a few months, days, or even hours. For
example, according to FAA officials, insured flights can be in operation for
only a few hours and only a portion of a flight—as the plane flies through
zones excluded by commercial policies—may be covered. In addition,
given the extraordinary conditions surrounding the issuance of federal
war-risk insurance, the level of risk assumed can change rapidly. For these
reasons, MARAD officials also stressed that risk assessment is an on-going
process, requiring continuous reassessment.

Both MARAD and FAA officials told us that because of the two programs’
infrequent activation and extremely rare losses, there is a lack of historical
program data for risk assessment. As noted above, according to FAA
officials, aviation war-risk insurance has only been issued during a few
periods since 1975. MARAD officials also stated that its war-risk insurance is
activated infrequently and remains active for short durations, usually less
than a year. Further, not only is the issuance of federal war-risk insurance
infrequent, but claims under the programs have also been extremely rare.
According to agency officials, the Aviation War-Risk Insurance program
has paid out only four claims totaling about $151,000. According to an
agency official, the only claims to date under MARAD’s war-risk insurance
program occurred during the Vietnam Era and totaled approximately
$110,000 and were reimbursed by the Navy under Section 1205.

Further, officials from both agencies told us that historical information
from commercial war-risk insurance may not be useful in assessing the
risk undertaken by their programs because commercial information often
is not readily available or applicable. For example, officials from both
agencies stated that the basis for setting commercial premiums generally
is not released by private sector companies. In addition, FAA officials
described the goals and operations of the Aviation War-Risk Insurance
program as significantly different from those of commercial aviation
insurance because federal war-risk insurance is activated only
infrequently, for very short durations and under extreme conditions. MARAD
officials added that historical loss information from commercial policies is
of limited use for projecting future losses of its insurance programs
because commercial policies also cover events which are not war-related.
Nevertheless, MARAD officials told us that, when available, they do consider



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Other Insurance Programs




the quoted commercial sector rate for a particular voyage as a starting
point in the risk assessment process.

Because of the above limitations, risk assessment for the federal war-risk
programs currently relies heavily on expert judgment. Premiums for both
programs are set in consideration of the risk involved, U.S. policy
interests, and to encourage the participation of commercial insurers. In
general, risk assessment for the programs involves the subjective
evaluation of numerous factors associated with a particular flight or
voyage. According to FAA officials, they consider factors such as (1) the
hull value, (2) the potential liability for passengers, crew, cargo, and losses
on the ground, and (3) the apparent danger associated with flights into the
area(s) excluded by commercial insurers. They told us that, in assessing
the risks associated with a particular area, they consider available
information on potential dangers, such as intelligence information on
terrorist groups, and the types of weapons involved in the conflict. If
available, they consider historical losses in the area.

FAA officials also noted that although they do not currently use a standard
risk assessment model, they are looking for ways to improve risk
assessment techniques. For example, they have developed a database of
war-risk incidents since 1980 containing (1) the type of incident, (2) the
region where the incident occurred, (3) a text section describing the
incident, and (4) the value of the aircraft. According to officials, this
database will be used as a reference and training tool. In addition, the
agency is studying the actuarial process used by the private sector.
Although not directly applicable to their programs, they said they are
interested in what might be learned from the private sector methods.

MARAD  officials also described their risk assessment process as ad hoc and
judgmental. For example, during the Persian Gulf conflict, a committee
was established to determine premium rates. They said that a number of
factors were considered in assessing risk, such as (1) the destination of
the vessels, (2) the extent of the military threat, (3) the current
commercial rates, and (4) the value of the vessels. Although in a few cases,
historical information can be useful in assessing conditions, such as the
military threat in a particular area, MARAD officials noted that the number
of cases in which historical information is available and useful is very
limited. According to agency officials, an outside consultant, the American
War-Risk Agency, has provided advice on risk assessment.




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                                 Overall, agency officials for the war-risk insurance programs expressed
                                 concerns that accrual-based budgeting may not be feasible or useful for
                                 their programs. They described the infrequent and limited issuance of
                                 insurance and the resulting lack of historical experience as a key obstacle
                                 to developing risk-assumed estimates and using accrual-based budgeting
                                 for these programs. Because of the programs’ unique roles, it is difficult to
                                 effectively pool risk or to develop discernible loss patterns. Further, the
                                 emergency (standby) nature of the programs makes it difficult to know in
                                 advance when the programs will be activated and limits the time available
                                 for risk assessment. FAA officials stated that, in their opinion, it was not
                                 feasible to generate a reliable risk-assumed estimate for the budget. MARAD
                                 officials provided a similar assessment for their program, stating that given
                                 the nature of the program, reliable estimates of the risk assumed could not
                                 be developed.


Implementation
Considerations for the
War-Risk Insurance
Programs
Adequacy of Current Budget   •   Although infrequently activated, when in force the war-risk insurance
Reporting                        programs expose the federal government to potential unfunded claims
                                 without recognizing these potential funding shortfalls at the time the
                                 insurance is extended. For each of the war-risk programs, one major loss
                                 could deplete the program’s fund balance and leave a portion of the claim
                                 unpaid.
                             •   The amount of risk assumed by the federal government is not explicitly
                                 recognized in the budget process.
                             •   However, the government’s budgetary exposure may be limited because of
                                 the war-risk programs’ infrequent activation and limited coverage.

Issues in Implementing an    •   Significant uncertainty will surround the risk-assumed estimates for the
Accrual-Based Budgeting          war-risk insurance programs because of the volatile nature of the risk and
Approach                         the lack of relevant historical data.
                             •   The unique role of war-risk programs may make the use of accrual-based
                                 budgeting difficult because the need for coverage may not be apparent
                                 during the normal budget cycle.
                             •   A decision would have to be made as to whether accrual-based budgeting
                                 should be applied only to the premium portion of the war-risk programs or
                                 to the nonpremium portions as well. If applied to the nonpremium




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                            Other Insurance Programs




                            portions, additional implementation issues would have to be resolved. For
                            example, for insurance provided under indemnification agreements, it
                            would have to be determined whether the insured agency or FAA should
                            report the accrued cost for the risk assumed by the government.
                        •   The combination of the catastrophic nature of war-risk losses and the
                            limited number of policies issued may impede the establishment of
                            sufficient reserves, even if costs were measured on an accrual basis.
                        •   The use of accrual-based budgeting may not lead to significant policy
                            changes because of the war-risk programs’ limited activation and unique
                            roles.


                             Budget Account: Vaccine Injury Compensation Program Trust Fund
National Vaccine                              (20-8175-0-7-551)
Injury Compensation
Program (Post-1988)46       Agency: Department of Health and Human Services (HHS)

                            Bureau: Health Resources and Services Administration (HRSA)


Purpose                     The National Vaccine Injury Compensation Program (VICP) was established
                            by the National Childhood Vaccine Injury Act of 1986 (Public Law 99-660).
                            VICP, which went into effect in October 1988, is a no-fault alternative to
                            state tort law and private liability insurance systems for compensating
                            individuals, including adults, who have been injured by vaccines routinely
                            administered to children. The program was intended to improve the
                            stability of the childhood vaccine market by reducing the adverse impact
                            of the tort system on vaccine supply, cost, and innovation.47 VICP is
                            administered jointly by the United States Court of Federal Claims, the

                            46
                              Claims resulting from vaccines administered prior to October 1, 1988, are treated separately
                            (pre-1988 program) and paid with general fund appropriations. The deadline for filing claims under the
                            pre-1988 program has expired. This appendix provides a general summary of the ongoing post-1988
                            program.
                            47
                              The intent of the Congress is reflected in H. Rept. 908, 99th Cong., 2nd Sess. (1986) which states
                            “manufacturers have become concerned . . . with the availability of affordable product liability
                            insurance that is used to cover losses related to vaccine injury cases . . . there is little doubt that
                            vaccine manufacturers face great difficulty in obtaining insurance.” Agency officials, however, contend
                            that VICP is not an insurance program because (1) there is no insurance contract between VICP and
                            manufacturers, (2) the program is funded through an excise tax on manufacturers and not premiums,
                            and (3) a lawsuit must be filed to receive compensation. As noted in chapter 1, there is not universal
                            agreement on which programs constitute federal insurance, but the factors cited by the agency do not
                            necessarily preclude classifying VICP as insurance. Explicit insurance contracts do not exist for many
                            federal insurance programs and a program’s financing mechanism does not affect the government’s
                            liability. The requirement that injured persons begin compensation proceedings in claims court has no
                            bearing on whether to classify VICP as insurance since the party being provided something akin to
                            liability insurance is the manufacturer.



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                               Department of Health and Human Services (HHS), and the Department of
                               Justice (DOJ).


Coverage                       VICP compensates individuals or families of individuals who have been
                               injured by childhood vaccines, whether administered in the private or
                               public sector.48 Compensation for petitioners alleging vaccine-related
                               injuries is provided through a no-fault administrative hearing process
                               conducted by Special Masters of the U.S. Court of Federal Claims. The
                               vaccine manufacturer and whoever administered the vaccine are not
                               involved as parties to the proceedings. Awards for vaccine-related deaths
                               are limited to $250,000 plus attorney’s fees and costs. There is no
                               limitation on the amount of an award in a vaccine-related injury; however,
                               the law does contain certain restrictions.

                               Petitioners may not obtain compensation from both the program and
                               litigation. Claims arising from post-1988 claims in excess of $1,000 or of an
                               unspecified amount must be processed through VICP before a civil suit may
                               be brought against a vaccine manufacturer or administrator.


Eligibility Requirements       An individual claiming injury from a vaccine must file a petition for
                               compensation with the claims court. In order to qualify for compensation
                               a petitioner must:

                           •   show that an injury found on the Vaccine Injury Table occurred within a
                               specified period of time after receiving a vaccination, or
                           •   prove that the vaccine caused the condition, or
                           •   prove that the vaccine significantly aggravated a pre-existing condition.

                               The Vaccine Injury Table lists specific injuries or conditions and the time
                               frames in which they must occur after a vaccine is administered.
                               According to HRSA, the Injury Table is a legal mechanism for defining
                               complex medical conditions and allows a statutory “presumption of
                               causation.”49




                               48
                                 VICP compensation is secondary to all insurance coverage except Medicaid.
                               49
                                 Most claims allege that a “Table Injury” occurred because it is much easier to demonstrate a Table
                               Injury than to prove that a vaccine caused a condition. However, compensation is not awarded if the
                               court determines that the injury or death was due to a cause unrelated to the vaccine.



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                    Other Insurance Programs




Program Financing   The Vaccine Injury Compensation Program Trust Fund is supported by
                    revenues from an excise tax on vaccine manufacturers and interest earned
                    on fund balances invested in Treasury securities. Each vaccine has a
                    predetermined per dose excise tax rate.50 According to HRSA officials, rates
                    are related to “perceived” risk but are not based on empirical risk
                    assessment. Gross excise tax receipts are reduced by 25 percent before
                    being transferred from the General Fund to the Vaccine Trust Fund.51

                    The Vaccine Trust Fund has a significant and growing balance. The fund
                    balance as of the end of fiscal year 1996 was $1.0 billion. Although
                    significant uncertainty surrounds future claims, the risk of injury or death
                    due to vaccination is considered extremely small. Figure IV.10 shows the
                    excise tax receipts and budget obligations for claim payments for the
                    Vaccine Injury Compensation Trust Fund since fiscal year 1988.




                    50
                     Exported vaccines are not subject to these excise taxes, except where the export is to a U.S.
                    possession.
                    51
                     The Omnibus Budget Reconciliation Act of 1987 requires that net revenues be transferred from the
                    general fund to the VICP Trust Fund.



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Figure IV.10: VICP Excise Tax Receipts
Versus Obligations for Claim
Compensation, Fiscal Years 1988-1996     Nominal dollars in millions
                                         200




                                         150




                                         100




                                          50




                                           0
                                               88         89           90         91         92         93         94      95         96
                                                                                         Fiscal year

                                                                        Excise tax receipts   Obligations for claims


                                         Note: Excise tax receipts for fiscal year 1990 reflect the termination of taxes on December 31,
                                         1992 and reenactment of taxes effective August 10, 1993.

                                         Source: Budget of the United States Government, Appendix.




Current Budget Treatment                 The VICP (post-1988) is reported in the budget in a single account, the
                                         “Vaccine Injury Compensation Trust Fund.” The majority of the
                                         program’s spending is mandatory. Claim payments and the administrative
                                         expenses of the public health service are mandatory while the
                                         administrative costs for the Court of Federal Claims and DOJ are
                                         discretionary. Figure IV.11 shows the program’s budget estimates versus
                                         actual outlays from fiscal years 1989 through 1996.




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                                   Other Insurance Programs




Figure IV.11: Vaccine Injury
Compensation Program Budget        Nominal dollars in millions
Estimates Versus Actual Outlays,
                                   140
Fiscal Years 1989-1996
                                   120


                                   100


                                    80


                                    60


                                    40


                                    20


                                        0
                                              89          90      91         92          93        94         95         96
                                                                               Fiscal year

                                                                             Budget   Actual




Risk Assessment Methods            Risk assessment for the post-1988 VICP is complicated by several factors
                                   including (1) the program’s limited historical experience, (2) the lack of
                                   scientific evidence linking adverse events to vaccines, and (3) the dynamic
                                   or subjective nature of some variables such as injury coverage and
                                   settlement amounts. These factors increase the difficulty of assessing the
                                   many variables required to estimate the aggregate awards that are likely to
                                   be paid for vaccinations administered in a particular year, such as (1) the
                                   number of vaccines administered, (2) the frequency of adverse reactions,
                                   (3) the probability that petitions will be filed following an adverse
                                   reaction,52 (4) the filing of petitions for adverse reactions that are not
                                   attributable to vaccinations,53 and (5) the probability and amount of
                                   awards.

                                   VICP’s
                                        limited historical experience is a key factor in the uncertainty
                                   surrounding estimates of the program’s future costs. Although the VICP has

                                   52
                                     Not all individuals who are eligible for compensation under the program will file claims. For
                                   example, a 1994 Department of the Treasury report, entitled National Vaccine Injury Compensation
                                   Program: Financing the Post-1988 Program and Other Issues, points out that some victims of adverse
                                   reactions may be compensated through ordinary health insurance.
                                   53
                                    A petition does not require evidence proving a causal relationship between administration of a
                                   vaccine and an adverse event.



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Other Insurance Programs




been in existence since 1988, a full cohort of cases has not yet been
resolved. As a result, a 1994 Department of Treasury study concluded that
VICP had not been in existence long enough to project future outlays with
confidence.54 Both a Department of Treasury analyst who worked on the
report and HRSA officials reiterated that, until more historical data on
closed cases become available, estimates of the program’s future outlays
will be uncertain. Specifically, HRSA officials stressed that, in their opinion,
there is not sufficient historical evidence on the cost of claims to produce
meaningful estimates of the program’s future costs.

According to HRSA officials, scientific data also may not be useful in
predicting the program’s future claims. HRSA officials told us that although
the Food and Drug Administration (FDA) tests vaccines to prove safety and
identify potential side effects, these studies would not be very useful in
determining future claims under VICP because they do not estimate the
number of injuries that are likely to occur over a long period of time. The
Treasury report confirms that although new vaccines “may be proven to be
completely acceptable in clinical trials involving thousands of doses, a few
adverse reactions may still occur when doses are administered routinely to
millions of children.”55 HRSA officials added that calculating the risk
associated with vaccines is becoming increasingly difficult with the use of
combined antigens in single vaccinations.

In addition, HRSA officials expressed concern that the dynamic or
subjective nature of some variables makes it difficult, if not impossible, to
generate reasonable projections of the program’s future claims. For
example, agency officials noted that changes in the injuries covered by the
program make it more difficult to assess the amount of risk associated
with the program because a change in the injury table means a change in
the risk involved. Further, HRSA officials described award amounts as
case-specific and subjective. According to an HRSA official, the program’s
obligations are derived from court judgments which vary from year to year
and are not “susceptible to the type of actuarial analysis that is an integral
part of insurance schemes.” Additional factors, such as the introduction of
new vaccinations and changes in the recommended vaccination schedules,
may also complicate risk assessment.

Overall, HRSA officials expressed serious reservations about their ability to
produce reasonable projections of the program’s future costs and the use
of accrual-based budgeting for the program. HRSA officials stressed that

54
  Department of the Treasury, National Vaccine Injury Compensation Program, p. v.
55
  Department of the Treasury, National Vaccine Injury Compensation Program, p. 21.



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                                    Appendix IV
                                    Other Insurance Programs




                                    risk assessment has never been and is not currently used for VICP. They
                                    stated that, in their opinion, there currently is no meaningful way to
                                    quantify the program’s risk.

                                    The Treasury report concurred that until the program matures, program
                                    outlays cannot be estimated with confidence, but noted that “as the
                                    program matures sufficient program data will become available to permit
                                    more sophisticated methods of estimating future outlays to be used.”56 A
                                    Treasury analyst noted that it may not be necessary to establish causation
                                    between the vaccine and the adverse event in order to establish an
                                    estimate of the program’s future outlays. For example, as more cases are
                                    closed, it may be possible to establish a pattern between adverse events
                                    and award amounts based on historical data. However, changes in
                                    variables over time, such as injury coverage and the introduction of new
                                    vaccines, will have an impact on the usefulness of estimates based on
                                    historical data.


Implementation
Considerations for VICP
Adequacy of Current Budget      •   The current cash-based budget does not recognize the program’s future
Reporting                           claims costs. Because tax receipts are not matched with potential claim
                                    payments, policymakers may not receive timely signals of the
                                    reasonableness of the program’s financing levels. However, there does not
                                    currently appear to be a funding deficiency.
                                •   The current cash-based budget may not prompt decisionmakers to
                                    consider the implications of changes in the level of risk assumed by the
                                    government at the time the changes are made.

Issues Associated With          •   Both the magnitude and timing of the cost of VICP (post-1988) future claims
Implementing an Accrual-Based       are uncertain.
Budgeting Approach              •   HRSA officials expressed concern about the staff resources required to
                                    implement an accrual-based budgeting approach.




                                    56
                                      Department of the Treasury, National Vaccine Injury Compensation Program, p. v.



                                    Page 217                           GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Appendix V

Comments From the Office of Management
and Budget

Note: GAO comments
supplementing those in the
report text appear at the
end of this appendix.




See comment 1.




See comment 2.



On p. 5.




                             Page 218   GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Appendix V
Comments From the Office of Management
and Budget




Page 219                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                 Appendix V
                 Comments From the Office of Management
                 and Budget




See comment 2.




Now on p. 22
and p. 23.




See comment 3.


Now on p. 89.




                 Page 220                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Appendix V
Comments From the Office of Management
and Budget




Page 221                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
                 Appendix V
                 Comments From the Office of Management
                 and Budget




See comment 4.




                 Page 222                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
               Appendix V
               Comments From the Office of Management
               and Budget




               The following are GAO’s comments on the Office of Management and
               Budget’s letter dated July 1, 1997.


               1. We have incorporated OMB’s technical comments in the report as
GAO Comments   appropriate but have not reprinted them in this appendix.

               2. Section omitted.

               3. Discussed in the Executive Summary and the “Agency Comments and
               Our Evaluation” section of chapter 8.

               4. Statements omitted.




               Page 223                    GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
Appendix VI

Major Contributors to This Report


                        Christine E. Bonham, Assistant Director
Accounting and          James R. McTigue, Jr., Evaluator-in-Charge
Information             Elizabeth A. McClarin, Senior Evaluator
Management Division,    Eileen T. McGowan, Intern

Washington, D.C.
                        Carlos E. Diz, Attorney
Office of the General
Counsel




(935218)                Page 224                  GAO/AIMD-97-16 Budgeting for Federal Insurance Programs
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