Responding to WMD Terrorism Threats: The Role of Insurance Markets by Dwight Jaffee and Thomas Russe

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Responding to WMD Terrorism Threats The Role of
Insurance MarketsbyDwight Jaffee and Thomas
Russell

• Class presentation, October 22, 2009
• Dwight Jaffee

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Natural Disasters Dominate Insured Losses of
Catastrophic Events
WMD attack would surely create 100 billion in
insured losses, some estimates exceed 700
billion. Financial crisis even more!
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Insurance and Catastrophic Events

• Insurance offers three key benefits that help an
  economy limit the cost of catastrophic events,
  natural or manmade, WMD or conventional
• Risk sharing and transfer (Utility/welfare gain)
• Mitigation (Reduce actual losses)
• Price discovery (Efficiency gain).
• Sidebar on the US Subprime mortgage crisis
• Credit default swaps are insurance/financial
  contracts designed to protect investors from
  borrower default
• But it appears a primary CDS protection
  seller--AIG--may have added to the crisis by
  motivating risk-taking.

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The Economics of Mitigation Through Insurance

• No insurance Strong incentive to carry out
  mitigation investments to avoid expected losses.
• Insurance with risk-based premiums Incentive to
  carry out mitigation remains as long as premium
  saving exceeds investment cost. One
  problemIndividuals often myopic in investment
  decision.
• Insurance without risk-based premiums/subsidy
• This discourages mitigation/encourages
  risk-taking.Sadly, government insurance tends
  to take this form.
• Absence of risk-based premiums does oppositeNo
  premium saving gt Reduce investment.Insurance in
  this case encourages risk-taking!
• Most government insurance fails, as we will see
  in a minute, to imposed risk-based premiums and
  is often subsidized in addition, encouraging
  citizens to put themselves in harms way!
• Post-disaster relief also works against
  mitigation.

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Economics of Catastrophe Insurance Supply

• Consider a 100 billion event that is expected to
  occur once a century--the hundred year event.
• Actuarial premium 1 billion.
• If event occurs much before year 100, bankrupt
  insurer.
• If event occurs after year 100, you have profits.
• Would you bet your career and profitable firm on
  this?
• Add ambiguity aversion insurers wont insure!
• The insurance industry is designed for those
  things that happen with great frequency and don't
  cost that much money when they do. It's the
  infrequent thing that costs a large amount of
  money to the country when it occurs -- I think
  that's the role of the federal government.
  Edward Liddy, President Allstate

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Catastrophe Insurance Inevitably Becomes
Government Insurance

• Great Depression created FDIC and FHA.
• Floods in 1950s and 1960s led to National Flood
  Insurance Program (Sell financing until Katrina).
• Hurricane Andrew lead to Florida Insurance Fund.
• Northridge Earthquake created CA EQ Agency.
• And 9/11 created Terrorism Risk Insurance Act.
• Common features of government insurance
• Almost impossible to impose risk-based premiums
• Almost impossible to avoid cross subsidization
• But when private markets fail, who you gonna
  call?

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The Losses from the 9/11 Attack
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Terrorism Risk Insurance Act of 2002

• Prior to 9/11, casualty insurers provided
  terrorism coverage at no cost as part of all
  risks coverage.
• The 35.9 billion in insured losses primarily on
  foreign reinsurers no bankruptcies, but chagrin.
• Insurers and reinsurers immediately withdraw
  terrorism risk from their policies.
• Mortgage and construction industry predicted
  economic collapse as a result.
• None of that happened one lesson is that
  self-interest is not a good economic forecaster.
• Nevertheless Congress passed TRIA 11/2002.

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Key TRIA Features

• Insurance features
• Deductible Private insurers retained financial
  risk for a substantial lower tier of losses.
• Coinsurance For a middle tier, government
  reinsured 80 of all losses.
• Stop loss No industry liability for losses in
  excess of 100 billion.
• Pricing Free, courtesy of the US government!
• Make available All insurers required to offer
  insurance on terms used prior to 9/11.
• Temporary stated sunset date December 2005.

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(Nothing is so permanent as a temporary
government program, Milton Friedman)

• In December 2005 TRIA extended for 2 years, then
  in December 2007 TRIA extended for 7 years.
• Deductible, coinsurance, requirements notched
  upward no government cost for a 9/11 replay.
• But free insurance/100 billion liability limit
  remain.
• Evaluation
• Make available clause has worked remarkably well.
• Private industry sets prices, covers most losses.
• Is government safety net at upper tiers
  essential?
• Industry, of course, says it is essential.
• The same industry then writes 300 billion of CDS
  policies.
• We will never know because it crowds out private
  market.

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What About WMD Terrorism Insurance?

• The make available TRIA clause requires
  insurers to offer terrorism insurance under the
  same terms and conditions as prior to 9/11
• Since most policies excluded WMD coverage, no
  requirement for insurers to offer this coverage
  now.
• On the other hand, TRIA does reinsure any WMD
  terrorism coverage that the insurers choose to
  offer.
• But few if any have volunteered to offer WMD
  coverage.
• What is going on? What to do about this?

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Potential Losses from WMD Terrorism Attacks
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Potential Losses from WMD Terrorism Attacks

• Intriguing facts
• Workers Compensation laws require insurers to
  make payments even if WMD attack.
• A major part of any WMD losses will be Workers
  Comp.
• So why do they insure Workers Comp, but not other
  losses?

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Private Insurers are Simply Incoherent When It
Comes to WMD

• They gladly write Workers Comp (WC) contracts,
  even though WC losses would be 50 of most WMD
  losses.
• They also voluntarily ensure US nuclear plants.
• Tversky and Kahneman (1973) note that decision
  makers are subject to an availability bias,
  in which ease of imagining creates artificially
  higher judged probabilities.
• A terrorist nuclear bomb image fits the bill.
• Orjust take a subsidy when it is available.

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Irrationality with Small Probabilities

• Even with the September 11 attacks included in
  the count, the number of Americans killed by
  international terrorism over the period
  1975-2003 is not a great deal more than
• the number killed by lightning,
• or by accident-causing deer,
• or by severe allergic reactions to
  peanuts.These, of course, are all insured
  risks!
• In almost all years, international terrorist
  deaths is not much more than the number who drown
  in bathtubs in the United States--some 300-400.

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Market Based Policy Options

• Insurers and reinsures remain a very hard
  sell.Capital market investors may be more
  rational.
• Insurance-linked securities Catastrophe Bonds
• Insurer sells bond, proceeds put in escrow until
• If cat event does not occur, investors gets
  funds.
• If cat event does occur, insurer gets the funds.
• This can be diversified among investors, zero
  beta.
• Slowly expanding, but capital market investors
  still require exceptionally high compensation
• Bond with 1 expected annual loss, often require
  3 annual premium or more.

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Public Policy 1Expand TRIA To IncludeMake
Available for WMD Attacks

• If WMD losses were added to the make available
  clause, industry losses for a 1 trillion event
  would still be capped at 20 of direct written
  premiums (say 40 billion) plus 15 of the
  remainder up to 100 billion (say 9 billion), a
  total of 49 billion before tax. Hardly a show
  stopper.
• Not popular with industryAmerican Insurance
  Association (2007) The program would function
  most effectively if it provided an economic
  framework through which insurers are able to
  offer coverage enhancements without putting their
  solvency at risk This cannot be accomplished
  simply by imposing a CNBR make available
  mandate.

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Public Policy 2 Transition to Approach 2014

• Introduce explicit, actuarial, TRIA premiums.
• 3.5 growth rate in premiums would increase
  industry deductible to about 50 billion by 2014.
  
• Primary insurers will demand reinsurance to cover
  the deductible and this should revive the private
  terrorism reinsurance market.
• At some point, premiums from private market
  reinsurers will be less than the government
  program. Eureka!
• We do have experience with such competitionFHA
  versus private mortgage insurers, etc.

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Public Policy 3Ex-Post Lender of Last Resort

• Recent Fed/Treasury subprime crisis bailouts
  confirm the government as the lender of last
  resort.
• WMD terrorism insurers, surely have a similar
  claim on the governments lender of last resort
  resources
• Insurers facing bankruptcy as result of terrorism
  loss claims would have right to borrow from
  Fed/Treasury just as did our banking firms.
• Florida did this to refund its Hurricane Fund.
• Major issue is collateral. Banks, in principle,
  had sound collateral, although this was not
  true.
• Insurers have ongoing business as collateral.
• Should require private/public sharinglet the
  private market set the price the government
  receives.

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Public Policy 4Ex-Ante Auction of Cat Bonds

• No need to wait until event for the government to
  guarantee its resources to insurers.
• Government could auction reinsurance in any
  variety of forms. Simplest is for government to
  buy WMD Terrorist Risk Cat bonds. Benefits
• Government should recognize that this likely
  reduces the need for ex-post government gifts.
• Provides insurers full reinsurance, thus
  activating the market for WMD insurance.
• Also would help create an active private market
  for all flavors of catastrophe bonds.
• These bonds would have an industry loss
  trigger, so may not benefit the particular
  insurer. One solution is to make them
  transferrable.