Brookings-Wharton Papers on Financial Services 2004 (2004) 139-187
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Insuring against Terrorism:
The Policy Challenge
The terrorist attacks during the past decade in London, Israel, the United States, and elsewhere have spawned an interest in understanding not only how governments can mitigate terrorism risk but also how governments might help to finance future losses. A burgeoning academic literature—and an intense lobbying effort by various industries—have argued that government assistance is needed due to a host of problems: the large size of potential losses, the difficulty of pricing the losses, the government's existing role as the guarantor of last resort, asymmetric information, the relationship between terrorism losses and government military policies, and other reasons. These arguments served as an important catalyst for the Terrorism Risk Insurance Act (TRIA) that President Bush signed into law in November 2002. Although TRIA's passage was held up in Congress for almost a year over a debate on limiting tort actions, both Democratic and Republican leaders supported the act.
Over the past fifty years, the public has accepted a larger role for the government in insuring natural catastrophic losses.1 The general acceptance of the U.S. government's role in financing non-natural terrorist [End Page 139] losses, therefore, is probably not surprising, especially since the losses are partly in the government's control.
This paper takes a contrarian view. I argue that mostly unfettered insurance and capital markets are capable of insuring large terrorism losses, even losses ten times larger than the $40 billion loss incurred on September 11, 2001. A $400 billion loss in capital markets is common. U.S. capital markets alone routinely gain or lose $100 billion on a daily basis and often several trillion dollars on a monthly basis. Moreover, a significant amount of these risks can be traced to new companies that have very little history or few close substitutes from which investors can accurately assess future earnings. Furthermore, a significant amount of the net earnings of most corporations is influenced by the government's nonmilitary policies through a vast sea of tax regulations, oversight regulations, and torts. Despite these numerous problems and government policy risks, investors provide enormous liquidity to U.S. firms, producing one of the most efficient mechanisms for financing risks that has ever existed. Product and environmental liability markets have also remained vibrant despite shifting court standards during the 1970s and 1980s that generated large, correlated losses to insurers. Indeed, shifts in legal standards are probably less predictable than many terrorist acts.
So why do insurers appear to have a hard time providing insurance against a large loss that is "chicken scratch" in comparison to daily losses in other capital markets? This paper argues that capital and insurance markets are not to blame. Rather, if there is any "failure," it rests with government policies. Government tax, accounting, and regulatory policies make it costly for insurers to hold surplus capital. They also hinder the implementation of instruments that could securitize the underlying risks. In other words, the "market failures" that appear to justify government intervention in the terrorism insurance market are best viewed as "government failures." Correcting these policies would likely enable private insurers to cover both terrorism and war risks.
To be clear, the purpose of this paper is not to provoke. In general, I believe that government policy, including progressive income taxation, can sometimes play an important role in enhancing risk sharing.2 Indeed, one of the justifications for the government's largest historic intrusion into insurance markets—the creation of the Social Security system—is that people are either too myopic (if they do not anticipate retirement) or too [End Page 140] smart (if they strategically save too little in order to rely on public aid) for their own good or the good of society. But the idea that government tax and regulatory policies can hinder the development of insurance markets and securitization should not be surprising. For example, whereas the commercial mortgage-backed securities market was very small a decade ago, deregulation...