WASHINGTON–Despite claims to the contrary, federal reinsurance of terrorism risk is not working because the government program has crowded out private coverage at the highest tiers, according to a new academic study.
The paper, presented at a recent symposium on "Private Markets and Public Insurance Programs" held by the American Enterprise Institute, was written by Dwight Jaffee, a finance professor at University of California Berkeley Haas School of Business, and Thomas Russell, associate professor of economics at Santa Clara University.
Their paper also said that insurance against nuclear, biological, chemical and radiation attacks–"potentially the most worrying form of terrorism both in terms of size and its strategic value to terrorists"–remains largely unobtainable.
NBCR coverage is unavailable even though it is backstopped by the current government program, the extension to the Terrorism Risk Insurance Act passed by the Congress in late 2007, the paper added.
For example, according to data from the agency within Treasury that oversees the TRIA program disclosed earlier, only seven states bar exclusions for NBCR.
To deal with the problems presented by the current federal program, the authors of the study argued that for acts of conventional terrorism, the government should stop reinsuring this risk, or at the minimum remove subsidies and charge risk-based premiums.
This will eliminate the crowding out of the private market that is otherwise inevitable, the paper said. "Private markets are now large enough to handle losses in the range estimated by experts in this kind of attack, and further government presence and subsidies merely delay the reemergence of a private reinsurance market for this line," the authors wrote.
In resolving coverage of NBCR risk, the paper stated, one should look at the way the government has recently bailed out banks and securities stuck with toxic mortgage loans.
"Given the social importance of such coverage, we propose the government partner with private investors to recapitalize the industry in the aftermath of a major terrorism event," Mr. Jaffe and Mr. Russell wrote.
Put another way, the government would become the "lender of last resort" to the insurance industry following major catastrophic losses, the authors suggested.
They proposed that following a loss an NBCR insurer could recapitalize by selling bonds. "If these bonds were government insured," the authors said, "then there should be little impediment to recapitalizing the industry."
A more activist approach would have the government itself buy the bonds, giving the industry time to find alternative sources of capital.
Further, they said, "now that the provision of public equity capital to banks and other financial institutions has become an accepted practice, "there seems no reason why the same courtesy should not be extended to catastrophe insurers."
They also argued that helping out insurers suffering a loss from an NBCR event "may be even more appropriate for catastrophe insurers than for banks, since the problems of the banking industry arose at least in part from bad portfolio decisions so that bailing out these bad decisions raises problems of moral hazard."
"Catastrophe losses, in contrast, although to some extent controllable by the specific book of business, are in the main beyond the control of each insurer in the industry," the authors said.
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