Insuring against terror?

• Author: Manns, Jeffrey
• Position: Terrorism Risk Insurance Act

1. INTRODUCTION

   On November 26, 2002, President George W. Bush signed the Terrorism Risk Insurance Act, one of the centerpieces of his agenda to revive the economy and mitigate the economic threat posed by terrorism. (1) The Act was designed to address an alleged economic "crisis" caused by the unwillingness of insurers to issue terrorism insurance except on prohibitively expensive terms in the wake of the World Trade Center attacks. (2) The Act's proponents claimed that the unavailability of terrorism insurance not only left physical assets exposed or underinsured against terrorist acts, but also threatened to undermine the viability of capital projects that depended on access to terrorism insurance to secure bank loans. (3)

   The Act's solution to this problem was to create a temporary federal government reinsurance program lasting up to three years. (4) This program will fund ninety percent of the costs, above increasing annual deductibles, that the insurance industry may face from terrorist attacks. (5) The Act's professed, if somewhat nebulous, goal was to ensure the "widespread availability and affordability of property and casualty insurance for terrorism risk" (6) at "reasonable and predictable prices." (7) President Bush spoke for many of the Act's supporters in claiming that the greater access to terrorism insurance resulting from the Act would enable "builders and investors [to] begin construction in real estate projects that have been stalled for too long, and get our hard hats back to work." (8)

   This public-interest story (9) of terrorism insurance market failure that necessitated government intervention had resonance both with politicians and with a public wrought with emotion after the World Trade Center attacks and frightened by the specter of future acts of terrorism. (10) The federal government has a long history of offering subsidized insurance programs, such as flood insurance, that are rife with moral hazards and have often served no one's interests save the insured beneficiaries. (11) In spite of this fact, the market failure story for terrorism insurance has some economic credence. (12) Insurers face difficulties in estimating both the probability of terrorist attacks and their likely magnitude. (13) Following the World Trade Center attacks, perceptions of the probability of terrorism risks increased dramatically, (14) and the short-term capacity of terrorism insurance declined significantly. (15) Yet a year after the September 11, 2001 attacks, and before the Terrorism Risk Insurance Act's passage, terrorism insurance had once again become readily available for those facing small and medium risks of terrorism. Insurance premiums had begun to decrease gradually from high levels following the World Trade Center attacks. (16)

   Nonetheless, high-risk property owners and developers of infrastructure or expensive properties in large cities, such as Chicago, New York City, and Washington, D.C., often could still not acquire terrorism insurance policies at any price. (17) These high-risk parties combined with insurers to argue that government intervention was needed to overcome an alleged market failure in order to safeguard both the economy and homeland security. (18)

   Public justifications of the Act based on the market failure story covered an equally important subtext: rent-seeking by insurers, individuals, and corporations that face high risks from terrorism attacks. (19) These parties functioned as political entrepreneurs who successfully advocated the federal government's assumption of much of the economic risks posed by the threat of terrorist attacks. (20) Few politicians in an election year could resist jumping on the bandwagon of terrorism insurance intervention. This issue allowed politicians to demonstrate to the general public that they were addressing economic and homeland security issues, while simultaneously providing rents for their supporters. (21)

   Insuring against terror may pose new challenges for both insurers and insured, but successful rent-seeking is an all-too-familiar tale in American public policymaking. What distinguishes the terrorism insurance market is not the government's decision to intervene, but the reinsurance approach that the government adopted, which provides an innovative means of limiting the effects of the rents. (22) The strength of special-interest pressure made upwards redistribution almost inevitable in any government "solution." Nonetheless, this Note will demonstrate how the reinsurance approach is an innovation over past direct government insurance plans because of its incorporation of safeguards to limit the degree of rent-seeking and the distorting effects of government intervention.

   A number of legal scholars have highlighted insurers' use of terrorism exclusions in policies issued after the World Trade Center attacks in order to avoid liability exposure. (23) The legal literature, however, has thus far largely overlooked the Terrorism Risk Insurance Act. (24) Law-and-economics scholars have repeatedly made arguments against government interventions in insurance markets, relying on solid empirical examples of the distorting effects of past government interventions. (25) A few law-and-economics scholars have applied these largely valid economic critiques of government intervention to terrorism insurance. (26) This Note argues that the economic case for government intervention is stronger than these critics have acknowledged, yet shows how rent-seeking drove intervention. This Note concludes that the lasting legacy of the Act is the indirect intervention that the reinsurance plan entails.

   This reinsurance approach satisfies the overwhelming rent-seeking pressures, yet limits the distorting effects of intervention on private markets. The plan still contains loopholes for further rent-seeking that policymakers should seek to narrow, especially if this "temporary" program becomes effectively permanent. The use of deductibles and copayments, however, may serve as a model for federal insurance intervention that provides private insurers with incentives to limit the moral hazards and other rent-seeking abuses that have historically plagued direct government insurance programs. (27)

   Part II will show that there may be special justifications for intervention in the terrorism insurance market, but that rent-seeking interest groups overemphasized the "crisis" affecting terrorism insurance. This Part will analyze the special economic challenges that insurers face in estimating the probability of terrorist attacks and having the liquidity to cover the costs of catastrophic terrorist attacks. It will consider the theoretical case for the government's assumption of at least part of the terrorism risk. This Part will also assess the extent to which both private insurers and other affected parties successfully adapted to higher perceived terrorism risk in the year between the World Trade Center attacks and the Terrorism Risk Insurance Act's passage. While the economic case for intervention has some credence, this Part will show how politics drove government intervention. Part II will highlight how insurers and high-risk property owners successfully constructed terrorism insurance as a public rather than as an exclusively private problem to provide cover for their rent-seeking agenda. The linkage of terrorism insurance with the economic downturn and homeland security provided politicians with the perfect opportunity to address pressing issues and also award rents to special interests.

   Part III will show that in spite of the Act's genesis in rent-seeking, the design of the government reinsurance plan represents significant progress compared to direct, subsidized insurance. This innovative approach incorporates the almost inevitable upwards redistribution that subsidized government insurance entails and advances special interests far more than the general interest. (28) Nonetheless, the plan's employment of market pricing by insurers limits rent-seeking. The use of copayments and deductibles reduces moral hazards and limits the degree of risk shifting to the federal government. The Note concludes that the plan's pragmatic attempt to balance overwhelming rent-seeking pressures with economic safeguards may form a model for containing the rent-seeking and distorting effects of government intervention in a world of policymaking characterized more by political failures than by market failures.

2. THE CASE FOR GOVERNMENT INTERVENTION

   1. The Economic Challenges Facing Terrorism Insurance

      1. How Pure Insurance Markets Work

         Before beginning a discussion of the special economic challenges posed by terrorism insurance, it is necessary to establish clearly what insurance is designed to do. This, in turn, may help to elucidate when market failures may be taking place. Insurance covers risks that are not preventable for a lower cost than the expected loss. For example, no amount of preventive measures can fully eliminate the probability of property damage from natural catastrophes. Pure insurance provision allows individuals to pay the expected value of their loss plus a premium for transaction costs up-front to limit the economic consequences of a given risk's occurrence. (29) Insurers eliminate the disutility of risk by pooling a given insured's risk with other risks with which it is not correlated and transforming risks individuals face into almost certain costs. (30)

         Insurers use measurement costs and transaction costs to calculate insurance premiums. (31) Measurement costs are the product of the estimated probability of an insured risk's occurrence and the economic cost of loss if the insured risk occurs. (32) Measurement costs form the primary basis for calculating insurance premiums, and their precision rests on the accuracy of the underlying information. Insurers also charge additional fees for transaction costs incurred in insurers' administration of the...