Risk Transfers: Loans, Loan Guarantees and Insurance
The federal government uses subsidies to redirect resources and influence economic decisions. One method of subsidization is transferring some or all of the financial risk of an economic activity to the federal government. By reducing risk, the federal government encourages more people to undertake an activity. Such risk transfers are typically done through government credit programs, such as student loans, and insurance, such as federal deposit insurance.
The extent of a subsidy received under a credit or insurance program is generally the difference between the terms the recipient would get in a competitive market and those offered by the government. Click the links below for more detail on Federal credit and insurance programs.
- Loans & Loan Guarantees
- Insurance against Financial Risk
- Insurance Against Natural Disaster
- Insurance Against Security-Related Risks
In the case of direct loans, the government lends money directly to the borrower and services the loan by collecting repayments. When the government offers direct loans at below market interest rates, or terms more generous than what private markets would provide, there is a subsidy. Credit subsidies may also be provided when the government pays some of the interest or offers a grace period before the loan goes into repayment. Further subsidies may result from lower administrative fees than would normally be required by private lenders. For example, many student loans provide a subsidy to the borrower because they have lower interest rates than a standard loan. In some cases the government also pays for the interest on the loans while the borrower remains in school.
In the case of a government loan guarantee, a private lender disburses the loan to the borrower, and the government acts as the guarantor of the loan by agreeing to make payments should the borrower fail to do so. Such a guarantee often allows a borrower to secure a loan at a lower interest rate than it could otherwise obtain. Even if the interest rate is a market rate and the loan is repaid in full there may be a subsidy if the borrower did not pay an upfront fee for the guarantee, as they would from a private lender. In addition, a government guarantee encourages lenders to offer loans to borrowers to whom they might otherwise not extend credit.
The way that the federal government accounts for the costs of federal credit, including the associated subsidies, has changed over time. A significant shift occurred with the Federal Credit Reform Act of 1990, which requires that the government use an accrual basis rather than a cash basis to budget for loans, with the main difference being the timing of the recognition of the government's loss on the transaction. This change means that an estimate of the net present value of the expected loss on the loan is accounted for in the budget when the loan is disbursed. While a big step toward increasing transparency, the 1990 change has some shortcomings. As the Congressional Budget Office explains in a 2004 report "Estimating the Value of Subsidies for Federal Loans and Loan Guarantees," the government underestimates the subsidy amount of loans and loan guarantees. This lower estimate results from two omissions: first the government does not include the cost of administering the loan (though this is accounted for elsewhere in the budget, it is not included in the subsidy cost of the credit); and second, the government — using methods required under credit reform — does not include the cost of market risk when calculating net present value. This risk is included in the cost of private market loans. These exclusions systematically understate the cost of loans and loan guarantees to the government. (For more on calculating subsidies under credit reform, see this report.)
Over the years the government's involvement in direct loans has remained fairly steady while it has become the guarantor of an increasing number of loans. According to the Office of Management and Budget in the President's Budget for fiscal year 2010, the federal government had $286 billion outstanding in direct loans in 2008. In the same year, there were $1.4 trillion in government guaranteed loans on the budget. This makes the total outstanding federal credit $1.693 trillion. The largest category of both direct loans and loan guarantees is student loans, at $148 billion in direct loans and $415 billion in guaranteed student loans in 2008. Guarantees for home mortgage loans also make up a significant portion of government guaranteed loans. OMB estimates that the cost to the government of outstanding guaranteed loans through the Federal Housing Administration's Mutual Mortgage Insurance Fund in 2008 will be $448 billion.
The federal government operates a number of insurance programs. These include insurance of bank deposits against financial loss through the Federal Deposit Insurance Corporation; insurance of defined benefit pension plans through the Pension Benefit Guaranty Corporation; insurance against natural disasters,such as crop insurance and flood insurance; and insurance against security-related risks, such as war time insurance.1
Government insurance programs often provide a subsidy to beneficiaries. When lower than actuarially fair premiums are charged, a subsidy is provided to the insured. A key characteristic of government insurance programs is their lack of visibility in the federal budget. Insurance programs expose the government to trillions of dollars of contingent liability, yet these potential claims on taxpayers are not reported in the federal budget unless losses occur.2 For this reason it is difficult to obtain data on government insurance programs and the subsidies they provide.
Insurance programs are reported in the budget on a cash basis. They look like moneymakers for the government in most years because the premiums paid in good times outweigh the claims paid, even if future claims after a bad event swamp the premiums paid. Insurance programs also appear to be self-financing and less dependent on taxes, even though future claims may burden taxpayers. Further, they often target a relatively small group (such as farmers). For these reasons, indirect subsidies through insurance programs are politically appealing because politicians can take credit for visibly supporting specific constituents while also claiming that they are not spending taxpayer dollars.
The following sections look more closely at three categories of federal insurance: insurance against financial risk, insurance against natural disasters, and insurance against national security related risks.
Insurance Against Financial Risk
Before the financial bailout of 2008, two insurance programs in the financial sector — the Federal Deposit Insurance Corporation and the Pension Benefit Guaranty Corporation (PBGC) — were responsible for most of the trillions of dollars of government insurance exposure. Through the FDIC, the federal government insures depositors against the failure of banks up to $250,0002 per depositor. When an institution fails, a charge is made against the Deposit Insurance Fund, which is supported by fees imposed on the banking industry. The fund is also supported by a backstop line of credit from the U.S. Treasury that could be tapped if the fees were insufficient to cover losses. A rash of bank failures caused the fund's balance to drop from about $52 billion in the fourth quarter of 2007 to about $13 billion at the end of the first quarter of 2009.
The federal government also insures against the insolvency of firms with underfunded pension plans to pay out promised pension benefits (defined-benefits plans) through the PBGC. The largest 10 claims against the PBGC's single employer program from 1975 to 2007 totaled $32.6 billion. Nine of these 10 claims came after 2001; leaving the program at a $10.7 billion deficit in 2008 as compared to a $9.7 billion surplus at the end of 2000.
In addition to increasing the amount insured under federal deposit insurance, the government's response to the financial crisis included actions such as extending credit, guaranteeing more debt and assets and purchasing a number of mortgage-backed securities held by government sponsored enterprises. See these Subsidyscope posts for more on the recent activities of the Federal Reserve, the Treasury, the FDIC and Federal Home Loan Banks.
Insurance Against Natural Disasters
In order to insure against natural disasters, the government provides two main insurance programs — crop insurance and flood insurance. Crop insurance, administered by the US Department of Agriculture in conjunction with the private insurance industry, protects farmers against low yields and crop quality that may result from bad weather or insect damage. Flood insurance, administered by the Federal Emergency Management Agency within the Department of Homeland Security, provides insurance "to homeowners and businesses in communities that have adopted and enforced appropriate flood plain measures." At the end of 2008, OMB reports that 5.6 million policies collectively worth more than $1 trillion were in force in more than 20,200 communities. While disaster insurance programs can be large, on the whole they are smaller than insurance against financial insolvency.
Insurance Against Security-Related Risks
The federal government offers several types of insurance against acts of war and terrorism, including terrorism risk insurance, aviation war risk insurance, and maritime war risk insurance. Terrorism risk insurance — enacted in 2002 in the aftermath of the September 11, 2001 attacks — was set up as a temporary program to support the insurance industry. The budget includes estimates of the cost of the terrorism risk insurance; however, this does not represent the potential costs were there to be future attacks. The extension of the legislation — the Terrorism Risk Insurance Program Reauthorization Act — in 2007 is slated to sunset in 2014. Reflecting this extension, the insurance is forecasted to cost taxpayers $2.16 billion from 2009 — 2014, and $3.069 billion from 2009 – 2018 (spending less receipts from premium surcharges). The Analytical Perspectives of the President's Budget for fiscal year 2010 states that the "Administration proposes to lessen Federal intervention in this insurance market and reduce the subsidy to private insurers" (i.e., increase the private sector's share of losses).
Many airlines hold insurance policies against catastrophic events such as war or terrorism. After the September 11, 2001, attacks, third party liability war risk coverage that airlines carried through private insurers was canceled, and the cost of other war risk insurance coverage dramatically increased. As one of the many government responses, the Secretary of Homeland Security was required "to provide additional war risk insurance coverage for hull losses and passenger liability to air carriers insured for third-party war risk liability as of June 29, 2002." The Federal Aviation Administration has made such insurance coverage available; further, the Secretary of Homeland Security is authorized to limit an air carrier's third party liability to $100 million when loss stems from terrorism. Many airlines could be grounded without such coverage.
Backing these policies is the Aviation Insurance Revolving Fund of the Department of Transportation. This fund currently insures 62 air carries for between $80 million to $4 billion per carrier (median insurance is $1.8 billion). The fund contains $1.15 billion in premiums paid in as of the end of 2008, which the Office of Management and Budget states would be insufficient to "meet either the coverage limits of the largest policies in force ($4 billion) or to meet a series of large claims in succession." The federal government would be on the hook for any outstanding claims in the fund.
The government also offers a maritime war risk insurance program that makes insurance available to commercial ships during wartime. According to the Department of Transportation, the program, along with other Maritime Administration initiatives, "assures [Department of Defense] access to U.S.-flag commercial ships and crews during DOD mobilizations, and helps ensure the efficient flow of military cargo through commercial ports."
- Social Security is often called "Social" Insurance, but its key features sufficiently distinguish it from the other insurance programs considered here.
- The current level of $250,000 is a temporary increase through December 2009; it was raised from $100,000 in October 2008. Pending legislation would make the increase permanent beyond 2009.