Are Terrorism Risks Really Uninsurable?

The terrorist attacks of Sept. 11 are expected to result in over $40 billion in insured losses, and thus constitute the largest insured loss on record.

One month later, on Oct. 11, the Nobel prize for economics was awarded to three Americans–George Akerlof of Berkeley, Michael Spence of Stanford, and Joseph Stiglitz of Columbia–for their work on the role of information in markets.

It is ironic that these two events, which on the surface appear totally unconnected, in fact have a deep relationship. The link is that an understanding of the role that the cost of information and other transaction costs play in the economy can provide guidance on how policymakers can approach the design of a mechanism for insuring terrorism risks.

Following the events of Sept. 11, insurers and reinsurers are moving to exclude the terrorism risk from their polices. The removal of this cover would have grave consequences for existing and new commercial properties, as property owners and perhaps more importantly, lenders, would be exposed to risks that would threaten their very solvency.

As a result, the U.S. government, along with governments around the world, are considering measures to provide for terrorism coverage.

What is being said is that terrorism is an “uninsurable risk,” involving losses beyond the capacity of the private insurance market, and requiring the enormous resources of the federal government as backup.

But let us be careful with these concepts. Terrorism as such is now “perceived” to be uninsurable. Prior to Sept. 11 the perception was radically different–the coverage was practically given away.

Even after Sept. 11, it can be argued that not all terrorism acts need be viewed as uninsurable. For example, terrorism coverage for single-family homes would at this point appear to not involve abnormally high catastrophic exposures, beyond that already covered for natural perils like hurricanes.

When we examine these concepts in more depth, what is happening is not that the risk of terrorism as such has become uninsurable. Rather it appears that the existing mechanism of transferring the terrorist risk for events on the scale of Sept. 11 is not working.

The ultimate bearers of this risk, insurers and reinsurers, are saying that they are not willing to bear risks of this type. They are not prepared to expose their capital to another $40 billion type loss, at any price.

Can risks of $40 billion be transferred in the private sector of the U.S. economy? Yes, if the correct mechanisms are in place.

For perspective, the stock market transfers the financial risks of corporations every day. Following Sept. 11, stocks lost $1.38 trillion in value. Could the insurance industry have handled such a loss? With only $320 billion in total capital, the answer is obviously no. But the stock ownership mechanism, whereby profit and solvency risks faced by corporations are transferred to millions of investors, smoothly absorbed this loss.

In the global economy, and indeed in the U.S. economy alone, $40 billion is the proverbial drop in the bucket. With U.S. financial assets of about $20 trillion, Sept. 11 losses are hardly a blip on the financial radar screen.

Which is where we come back to our Nobel Laureate economists. The issue of terrorism risk is not that it cannot be transferred in private markets, but that information expenses and transaction costs make it difficult to effect the transfer.

Having the federal government backstop this risk reduces the transaction costs, as one single entity takes on all of the risks. But is that good? Obviously, in the short term if insurance is needed to keep a large part of the U.S. economic engine running, then the federal governments participation can be considered as almost essential.

But a federal solution involving transferring the terrorism risk to all American taxpayers involves inequities. For example, over time, are taxpaying Americans in small cities and towns around the country going to be comfortable with the notion that their hard-earned dollars are being put at risk to support the construction of high-profile luxury buildings in New York?

A government solution also carries with it the risks typical of any government program that overlaps the private sector, including excessive bureaucracy, inefficiency and misallocation of resources.

This would suggest that the program to be put in place by the federal government should be designed to allow for its own eventual demise and replacement by private sector mechanisms. The example of the Hawaii Hurricane Relief Fund comes to mind. This fund, set up to handle a critical insurance availability problem in Hawaii following Hurricane Iniki in 1992, closed its doors at the end of last year. The fund was structured to encourage its eventual replacement by the private sector.

Similarly, Pool Re in the United Kingdom, designed to provide terrorism coverage in that country, allowed for the growth of a competitive private sector, and, prior to Sept. 11, Pool Re had contracted substantially.

In summary, the potential risk of terrorism appears to be too much for the existing insurance system to handle. Hence, there is a clear role for the federal government to act to avoid a financial calamity.

However, this role should be carefully circumscribed and include strong incentives for the early re-entry of private sector mechanisms for risk transfer.

Sean F. Mooney, CPCU, is senior vice president, research director and economist at Guy Carpenter & Company in New York.

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, October 22, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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Are Terrorism Risks Really Uninsurable?

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