The Terrorism Threat to Insurance Markets
December 1, 2003Francis J. Menton
Francis J. Menton, Jr.
**The Federalist Society takes no position on particular legal or public policy initiatives. All expressions of opinion are those of the author or authors.**
The weeks since September 11 have seen representatives of one industry after another traveling to Washington to propose government solutions to the business problems they face after the attacks. Perhaps second only to the airline industry in the intensity and immediacy of its effort has been the insurance industry. Within a few weeks of the attacks leaders of the insurance industry, including senior executives of most of the largest companies, reached a consensus to seek a new Government-backed insurance program to provide coverage for future terrorist attacks. The Bush Administration has now apparently signed on to their program.
A government-backed terrorism insurance program is bad public policy. What the insurance industry and now the Administration have put on the table is perhaps the largest and most extraordinary corporate welfare program ever proposed. The principal beneficiaries (besides the insurance industry itself) would be developers and owners of some of our largest office properties, many of them billionaires, and owners of other commercial and residential properties in the highest-priced neighborhoods in the country. To keep these people from having to self-insure terrorism risk, the insurance industry proposes transferring that risk to the taxpayers, most of whom are far less wealthy than the beneficiaries, are not proper subjects to bear terrorism risk at all, and have never agreed to bear or been compensated for bearing that risk.
As described in several press reports, the justification given by the insurance industry for new Government-backed terrorism insurance goes like this:
"The insurance industry has traditionally provided coverage for acts of terrorism under standard property and casualty insurance policies, and in fact the industry is covering the losses from the World Trade Center attacks. It is desirable that insurance against terrorism should exist. But in the aftermath of the attacks, no one knows how to price insurance against terrorism, and the reinsurance market has disappeared. In this environment, the insurers simply can no longer provide traditional insurance against terrorism. The Government is the only institution with the size and financial resources to do it. Therefore, the Government should step in and provide the insurance that the private insurers can no longer provide."
The conclusion in this argument does not follow from premise. The argument ignores the fundamental difference between private insurance and Government-forced socialization of risk. It fails to deal with the many well-known disadvantages of Government-forced risk allocation. And it lacks a due regard for the importance of voluntary risk allocation (capitalism) as opposed to forced risk allocation (socialism) in bringing about successful economic performance.
The insurance industry proposal might have appeal if it were but a small step from private insurance for terrorist acts to government insurance, with the Government intervening simply to provide the required breadth of risk sharing. But the step from private insurance to a Government-backed system would not be small in any way. While private insurance and Government-forced risk allocation may look very similar to a property owner buying something named an "insurance policy" in either case, in fact Government-forced risk allocation is not close to or similar in any way to the voluntary private arrangements that go by the name insurance. From the point of view of economic impact, the two are polar opposites. Private insurance is a voluntary business arrangement where investors willing to bear risk sell their risk-bearing ability for an agreed price to others who want to shed risk. No coercion is involved. Risks move from those unable or unwilling to bear them to those able and willing to bear them. No one bears the risks of another unless he has voluntarily agreed to do so, and been compensated in an amount he has agreed to. Government-forced risk allocation has none of these characteristics. At whatever point the Government-forced mechanism kicks in, risks get allocated in accordance with the tax system, whose allocations bear at best a haphazard relationship - and at worst no relationship at all - to the allocations that would develop in a voluntary exchange. The Government forces the risk onto people who have declined to take it on at any price.
In a forced allocation system we know with certainty that many individuals will be inappropriately forced to bear risk. For example, young people just starting out need to save to start a household and buy their first home. Retired people need to move into a low-risk position in order to be sure that they can provide for an extended old age. In between the extremes of young and old are many examples of people who appropriately should not get stuck with the equity of a forced risk-shifting enterprise. One such example would be a coal miner in West Virginia who works long hours of overtime underground so he can send his handicapped daughter to a special school. Simply put, the universe of taxpayers includes many, many people who would not, should not and do not own equity interests in insurance companies. A Government-forced risk allocation scheme places upon these people risks they should not have to bear and have chosen not to bear.
Consider an example of how private insurance and Government-forced risk allocation would work in a hypothetical disaster. A recent Forbes magazine lists several real estate developers reported to have net worths of approximately $2 billion each, split about equally between properties in New York and properties outside New York. Such developers likely have terrorism insurance in their current coverage, but could not get it in a renewal. Suppose a terrorist gets a nuclear bomb into New York City and sets if off, leveling midtown. These developers each just lost half of their net worth, so they're down to about $1 billion each. With private insurance, they likely get much of that billion dollars back, at the expense of equity holders of insurance companies. Those stockholders voluntarily agreed to take on that risk. It is entirely likely that the equity value of many insurance companies would be lost entirely in such a disaster, but the stockholders knew that was a possibility going in. They have no legitimate gripe that their money is being used to give a billionaire back his second billion in the midst of widespread devastation.
The same does not apply to the result in a Government-forced risk allocation program. There the burden of restoring a developer's second billion falls on people who never agreed to have anything to do with that risk and are not proper subjects to bear it. In the various forms proposed by the insurers, the taxpayers simply take on the risk after some limit, potentially about $20 billion, to be borne by the private markets. In a worst-case terrorist strike -- such as a nuclear attack on New York -- the Government could find itself facing a liability of several trillion dollars, with few or no meaningful reserves accumulated to cover it. The Government's only means of paying such a liability are taxes: either an immediate tax increase (e.g., literally doubling the tax burden at the very time of national disaster) or borrowing and paying with future taxes, which imposes the exact same burden except spread over time. In either case, millions of ordinary taxpayers, many of them with severe problems of their own at such a time, must pay to restore the net worth of wealthy property owners. The payers would include the young family just starting out in Florida and trying to save to buy a home, the retired woman in California who has carefully placed all her savings in lowest-risk money market funds and Treasury bills, the coal miner in West Virginia who puts every spare dollar into the special school for his handicapped daughter, and millions of other ordinary, risk-averse, middle income taxpayers. The big beneficiaries would have names like Durst, Milstein, Reichmann and Trump.
There is no answer to the objection that Government-forced risk allocation transfers risk coercively to the wrong people. The attempted answer most commonly given by those supporting Government-forced schemes is necessity, that is, insurance of this type is necessary and no one but the Government can or will provide it, so therefore a Government-forced scheme is necessary.
Those advancing the necessity argument have failed to learn the lessons that the twentieth century has taught about the benefits of private risk allocation and the harms of government risk allocation. We cannot know how the markets will respond if terrorism risk is uninsured, and we cannot blame people for being concerned that there will be a period of uncertainty. But by this time we certainly know of the tremendous creativity of private markets, which have devised wonders from the computer to the internet to antibiotics to complex financial derivatives to the insurance markets themselves, that no bureaucracy could ever hope to have conceived. And we know that government risk allocation inevitably and immediately stifles the creativity of the markets and leaves the taxpayers at huge risk. We know that the FDIC and FSLC have stifled the development of alternatives like low-risk banks and multi-institution deposits. We know that the flood insurance program has incentivized thousands of millionaires to build beach front homes and that its foolishly low politically-driven premiums have crowded the private markets out of this completely insurable business. We know that farmers game the crop insurance program to get paid more from declaring a loss than they could ever hope to get from selling their crops. And these are just a few of many examples. If we buy into the necessity argument we will find ourselves having cut off market creativity and facing massive risk misallocation for decades or more.
We should make no mistake that a Government terrorism insurance program would be temporary. If you think there is any such chance, then you have never witnessed, as the author of this paper has, dozens of millionaire beach front homeowners making out checks to a politician at a fundraiser who has just given a speech promising to fight to the death to preserve Federal flood insurance. We've known since at least the 1980's that the FDIC is a mega-disaster in waiting, but there is no effort to abolish it. And if the insurance industry cannot price terrorism insurance today, how will it be better able to price such a thing one or two or three or twenty years from now?
Insurance - and particularly insurance in the form heretofore provided by the marketplace but suddenly no longer available - is just one of many possible risk-spreading methods that the market can devise. Other appropriate risk-spreading systems relevant to the subject of terrorist attack include financial devices like equity and debt mutual funds, REITs and broad-based securitized debt pools; and non-financial devices like setting up less-centralized cities that are less vulnerable to terrorism. In the absence of a Government-forced risk allocation scheme, the markets will get to work right away applying these and other alternatives to spread risk in an appropriate and non-coercive way. But once a Government-forced system gets instituted such alternative mechanisms will be slowed or altered in ways we can only imperfectly perceive, leading inevitably to a situation where unspread risks leave the Government, and thus the taxpayers, subject to massive hits when the risky events occur.
No one, of course, can predict the future with accuracy, and therefore we cannot know precisely how markets over time would deal with the risk of terrorism in the absence of any Government intervention. Undoubtedly we should credit the statement of the insurance industry that under current conditions the existing institutions do not have the ability to provide coverage in the exact form previously provided. One very likely possibility in the absence of coverage under standard traditional policies is that high-risk entrepreneurs will put together pools of capital and begin to offer very high priced and limited terrorism insurance policies. Concern that insurance markets seem to be temporarily closing should not blind us to the tremendous willingness of capitalists to take on risk in the insurance industry. The insurance industry provided coverage for oil tankers sailing into the Persian Gulf during the Gulf War (albeit at premiums of 20% or more of the insured value) and routinely provides coverage for such highly risky activities as satellite launches and wrecking of office buildings. To the extent entrepreneurs step up to provide terrorism insurance, if loss experience is favorable, those entrepreneurs stand to make a pile of money, which in turn will attract others to the business and gradually push prices down and availabilities up. This is exactly the process that, over many years, led to the development of our insurance markets as we know them. Of course, another possibility is that further major terrorist attacks will result in large losses and bankrupt whichever entrepreneurs have created such a new market.
But clearly the traditional form of insurance, named as such, is just one example of the many forms of risk-spreading that the financial markets might devise. A second example, already existing, is the REIT, or real estate investment trust. A REIT is simply a mutual fund that invests substantially all of its assets in equity interests in real estate. By contrast to traditional ownership of individual commercial buildings by one or a few equity owners, a REIT can have thousands or tens of thousands of owners and can own dozens or hundreds of properties, scattered around the country or beyond. Whereas in our previous hypothetical a developer stood to lose about half his net worth if a nuclear bomb went off in midtown New York, a broader-based REIT with assets scattered around the country might lose only a few percent of its net worth in the same attack. In a world without terrorism insurance the owners of a REIT would clearly know they are bearing the risk of terrorism, and it would be perfectly appropriate to see REITs take losses of 2% or 5% in a major terror attack rather than have taxpayers step in with a coercive bailout.
And REITs are just one example of the risk-spreading that the market can devise. Mortgages against real estate have traditionally been concentrated, one lender per building. But those risks can be and increasingly are widely spread through securitized mortgage portfolios, whereby packages of mortgages on scattered properties become the security for large debt issues marketed to thousands of investors, or to debt mutual funds in turn owned by thousands of investors. With mortgages packaged by the hundreds and sold together to thousands of investors, again any one terror attack is likely to cause a downturn of at most a few percent in the value of such a fund, a highly appropriate and non-coercive way to distribute risk.
Nor would the financial markets be the only markets at work to distribute this risk. In the absence of traditional insurance against acts of terrorism, people would undoubtedly consider the likelihood of acts of terrorism in deciding what kind of buildings to build or where to locate their businesses. Cities might become less concentrated, or skyscrapers less tall. Although we cannot predict with accuracy how the markets would develop, we do know that millions of individual decisions taking place against a backdrop of uninsured terrorism risk would be seeking new and creative ways to minimize or avoid that risk.
All that changes as soon as the Government steps in with a coercive risk socialization program. Now the millions of individuals who might seek creative ways to avoid or spread the risk have had their incentive to do so removed. Being sensible, they turn their energies elsewhere. Risk spreading devices that might have developed see their progress halted. Investors gladly put the products of their hard-earned dollars in harm's way in complete comfort that when the terrorist strikes, the Government will hit the taxpayers to pay the investors back. Market creativity ceases, and the Government guarantee locks in place business arrangements that are no longer appropriate.
The history of Government-forced risk socialization programs is a history of one disastrous misallocation of risk after another. Probably the largest and best-known such disaster was the savings and loan bailout of the 1980's, a gargantuan Government mistake whose lessons we seem almost completely unable to learn. In the decades before the 1980's, the Government set up the Federal Savings & Loan Insurance Company, FSLIC, a forced risk socialization program, to "insure" deposits in certain financial institutions that were restricted to investing in real estate. Although the FSLIC purported to be an "insurance" system backed by premiums paid by the S&L's, it was clear from the start that if any significant number of institutions failed at once the insurance fund would be inadequate and the taxpayers would be on the hook. During the 1960's and 1970's the financial markets began to develop alternative risk-spreading products that offered creative new ways to avoid wiping out depositors in times of financial crisis. Most notable was the money market fund, whereby a depositor, instead of risking his money in one institution, could buy an investment in a pool of institutions, so that even if several failed, he would lose only a few percent of his investment. But with the FSLIC promising a Government bailout in the event of widespread system failure, investors had no incentive to diversify their risks among institutions, nor did institutions have proper incentives to control the risks of their investments. In the 1980's the inevitable occurred: dozens of S&L's failed at the same time. The insurance fund ran out. And the Government stepped in to make good on its promises with taxpayer dollars, hundred of billions of taxpayer dollars, seized indiscriminately from rich and poor alike without the slightest attention to whether the target of the seizure should appropriately bear such risk; and then paid over to bail out at 100 cents on the dollar high rollers and cynical arbitrageurs who had chased premium interest rates at institutions known full well to be risky, but backstopped by the Government.
The real scandal of the S&L bailout was not just that the Government unnecessarily took hundred of billions of dollars from hardworking taxpayers to cover losses. It was that the losses themselves need never have existed, if only the Government, by avoiding the perverse incentives of forced risk allocation, had allowed the markets to develop other and better risk-spreading mechanisms, like the money market fund. Yet today the Government continues a comparable program for banks, known as the FDIC, and millions of investors continue to keep far more money at risk to the vagaries of the fortunes of a single financial institution than they ever would in the absence of such a promised Government bailout. The FDIC is a disaster waiting to happen, potentially several times larger than the FSLIC disaster, even though the raison d'etre of the FDIC has long since passed and preferable mechanisms of risk spreading are well known and at hand for the taking.
Yet far from having learned any lessons from the FSLIC disaster, we seem completely oblivious to its lessons. The insurance industry should be leading a charge to reform the FDIC out of existence (along with a host of other such Government coercive risk allocation programs for such things as hurricanes, floods, crop damage, and pensions). But where there is a risk for which the markets may have temporary trouble providing one form of traditional insurance product, there is a strong temptation to shift risks to the Government, and by extension to millions of unwilling or unknowing taxpayers.
It is likely that at least in the near future it will be difficult to spread the risk of terrorist attack with a product looking like traditional insurance and provided by insurance companies. The alternative risk-spreading devices discussed in this paper that markets may provide do not fall under the category of "insurance." In the absence of a Government backstop, the insurers undoubtedly see themselves losing market share and valuable pieces of business to others with alternative business models. With the backstop of a Government-forced risk allocation program structured as an addendum to traditional insurance policies, insurance company shareholders get a meaningful upside in the form of fees for selling a product now wrongly named "insurance," and those shareholders also get protection against any large downside risk. The taxpayers get no meaningful upside and an enormous gaping downside when the next terrorist strike hits.
The insurers do have a legitimate concern that state regulators will not let them out of taking on new terrorism risk in policy renewals. But there are many answers to that concern short of the drastic step of putting the taxpayers on the hook for potentially hundreds of billions or trillions of dollars of terrorism losses. In the first instance, they should at least go to the states and present their very persuasive case.
Finally, a personal note. The author of this briefing paper is an attorney of substantial net worth and owner of a valuable townhouse in downtown Manhattan. My house has undoubtedly lost much value in the last two months, and stands to lose more if I can't insure for terrorism. I do not seek to put this risk to the taxpayer. I am not an appropriate subject for taxpayer largesse, and neither are my neighbors, and for God's sake not the people who own the big office buildings down the street. I bought here because I thought it was a good risk and I wanted to take that risk. I still do. I recognize that there is no right to succeed without a right to fail, and I ask the Government not to take away my right to fail. If the big developers (who already have their billions) and the entire insurance industry want to give up their right to fail, I want no part of them.
Economic history, particularly in relation to Eastern Europe, teaches that bad economic performance stems from the forced socialization of risk. Prosperity comes from freedom, and cutting into our freedom by forcing everyone to bear unwanted risks inevitably cuts into our prosperity. If the general case for freedom is too abstract to be appealing, then the specific example of a hard-working lower middle class coal miner forced to help top up the net worth of a high-risk-taking billionaire at a time of disaster should at least give us pause. The insurers' proposed Government backstop should be rejected.