Just in time for the 12th anniversary of the Sept. 11 terrorist attacks, our friends at the Cato Institute have published an interesting new report that calls for letting the Terrorism Risk Insurance Program – the $100 billion federal backstop set up in the wake of the attacks –to expire when it comes up for renewal at the end of 2014.

That Cato wants TRIP to expire isn’t the interesting part. Cato opposed its creation, and opposed both of its extensions, in 2005 and 2007. As “minarchist” libertarians, Cato is ideologically opposed to nearly any government program one could imagine. At the other end of the spectrum, most of the property/casualty insurance industry – primary insurers and reinsurers, agents and brokers, and many large commercial insureds – is firmly committed to extending the existing program in its existing structure.

Rather, what’s interesting from our perspective, is what each side gets right and wrong about the issue, and parsing those arguments to find a middle-ground that both better protects taxpayers while also preserving a functioning market.

There is much in the Cato paper, authored by law professor Robert Rhee of the University of Maryland, with which we would agree. Rhee notes, for instance:

I have previously written that the commercial insurance and reinsurance markets are sophisticated, well resourced, and well capitalized, and that government intrusion into the workings of these markets through TRIA was unwarranted. The insurance industry absorbed the 9/11 losses and recapitalized lost capital, setting the stage for development of a market for terrorism risk and industry growth.

Rhee builds on that with data showing the private market appetite for terrorism insurance continues to grow. The reality is even better than Rhee realizes, because he’s working with three-year-old data. He cites Marsh’s 2010 terrorism insurance report, which showed increased capacity for terrorism risks and a big drop in pricing from 2008 to 2009, when the median premium rate fell from $37 per $1 million in coverage to $25 per $1 million.

In fact, in Marsh’s 2013 report, the broker finds that, for companies with more than $1 billion in total insured value, median rates are now $19 per $1 million, down from $21 in 2011. Marsh also notes that “capacity in the standalone terrorism insurance market has increased significantly over the years,” with companies now finding up to $2 billion of private reinsurance capacity available for standalone terrorism risks.

Indeed, with so much excess capital sloshing around the global reinsurance markets these days – much of it sourced from hedge funds, who have been setting up their own reinsurers or backing special purpose vehicles for catastrophe risk – reinsurers and large commercial property insurers appear more and more to have gotten over any hesitancy they once had about terrorism risks, at least in the property catastrophe lines. Earlier this month, in a report about a new $250 million terrorism facility set up by global broker Aon, The Insurance Insider website noted:

Competition in the terrorism market has become fierce as years of favourable claims experience draws more and more capital into the space.

In recent months XL has been making a big play in the terrorism market, hiring a number of heavyweight underwriters from Hiscox and offering $100mn gross lines.

Stephen Ashwell has been building XL’s terrorism book and has brought on board other Hiscox underwriters including David Guest in Singapore and Daniel O’Connell in London.

And early this year, The Insurance Insider revealed that Marsh had put together a 25 percent follow-form facility for London-led business in the sought-after class.

But Rhee concludes from these sorts of data points (which do show genuine progress) that “the insurance market is capable of providing terrorism risk coverage without a federal loss backstop.”

This is a bold claim. While the $2 billion per-risk capacity is nice, pulling the plug on TRIA would create a $100 billion hole in the industry’s terror-writing capacity. It is possible that private capital would be able to fill that hole completely, although it would certainly come at a significantly higher cost than today. But asserting that “insurers and private industry can shoulder their own losses,” as Rhee does, amounts to positing such an unknown and unknowable counter-factual that it would have to be called an article of faith, not science.

Indeed, an argument can be made that the single most important aspect of the TRIA law is NOT actually the federal reinsurance capacity that it provides, but its requirement that commercial property/casualty insurers must offer terrorism insurance in the first place. Marsh interviewed 70 of the largest commercial insurers back before TRIA’s original 2005 extension, and 68 percent of them said they would simply go back to excluding coverage for terrorism, should the program expire.

Reading his report, I would say part of the problem is that Rhee misapprehends the biggest challenge insurers face in writing terrorism coverage. He looks at the coverage  insurers readily make available for other tail risks – such as earthquakes and hurricanes – and concludes:

Terrorism risk is not more severe than other insurable risks such as natural catastrophes, and a federal backstop stakes public money to protect the insurance industry and subsidize the terrorism risk insurance premiums for commercial policyholders.

But the issue isn’t severity alone. Property insurers actually have a pretty good handle on the maximum severity they might face – it’s called the policy limits. No matter how big or catastrophic an event, and no matter the cause, an insurer will not have to pay out more than it insures. (This gets a bit more complicated in the casualty lines, and particularly workers’ compensation, where claims can be much more open-ended and persist literally for decades.)

What makes terrorism different than hurricanes is that terrorist acts are committed by human beings, and human behavior doesn’t submit easily to modeling. That means, first, that the frequency of terrorist events are much tougher to anticipate ex-ante. But it also means that terrorism doesn’t lend itself to effective risk mitigation in anything like the same way as other risks. If you put up storm shutters, a hurricane doesn’t plot to find other ways to hurt you.

Rhee does address some of these issues. And he correctly notes that most terrorist events are of relatively modest severity, with an impact that is more psychological than economic. That’s absolutely true. If the question is, would an insurer – or the entire insurance industry – be able to pay claims arising from terrorism, then an overwhelming portion of the time, the answer would be yes.

But what about when the answer is no?  As Nassim Taleb would put it, terrorism is a “fat-tailed” event.  A single loss event can be big enough to more than wipe out all the gains ever made to date. It’s been estimated that in Manhattan, a 10-kiloton bomb, smaller than the one dropped on Hiroshima, would kill half a million people and cause $1 trillion in economic damages. That’s more than the capacity of the entire global insurance industry.

This is particularly problematic for workers’ compensation insurers. Commercial property insurers not only get to set firm policy limits, they also can and do exclude coverage for so-called NBCR (that is, nuclear, biological, chemical and radiological) attacks. Workers’ comp insurers can’t do either. They must pay all valid claims, regardless of causation, on a no-fault basis. That forces them to find ways to price the unpriceable, while also contending with state regulators who tend to want to exercise their authority to impose price controls. The workers’ comp market has struggled with these exposures, even with the federal backstop, and there is a genuine risk that it could move into crisis – imperiling the already fragile jobs recovery – if that support were to be taken away.

In comments we submitted last year to the Federal Insurance Office, we proposed a three-part test for evaluating whether governments should ever be directly involved in providing reinsurance capacity. These were what we saw as the essential elements of the positive case for such an intervention:

  1. There is a strong and long-lived historical precedent that the government uses tax money to pay for the expense to be reinsured.
  2. The expense to be reinsured will not be covered by the private sector by ordinary means.
  3. The best available underwriting data is largely or entirely in the hands of the public sector and cannot feasibly be released.

We asserted that anywhere all three conditions did not apply – such as in the “national catastrophe fund” proposals that get floated in Congress from time to time –  the government absolutely should not be involved. And even if all three conditions are met, that doesn’t necessarily make it a good idea for the government to be involved.

For us, the terrorism backstop meets all three conditions, but we still would like to see movement toward more private market capacity.  In the near future, there are some obvious ways to do this. We would recommend raising the trigger level for federal coverage from the current $100 million to at least $1 billion, and ideally to $5 billion or $10 billion. There is just no plausible case that the private market would have trouble covering a $100 million event absent government assistance.

We also would propose raising the program’s deductibles from the current 20 percent of an insurer’s direct earned premium. The growth in private standalone capacity can easily fill in gaps here, and a failure to raise the deductible may actually be crowding out capacity that would otherwise come on-line.

And we think the industry should be paying a premium for coverage, just as it did for the Riot Reinsurance Program that was set up in the late 1960s in response to mass urban riots. With that earlier experience in federal reinsurance, the private market took over more or less organically. The string of riots died down, reinsurance prices fell and eventually, private coverage became cheaper than the government alternative.  If premiums were risk-based, then that also would have the benefit of using price signals to communicate information to the market.

In the end, we agree with Cato that a world without any federal insurance or reinsurance program is the world we want to live in. We disagree that simply allowing the program to sunset, without any regard to whether private capacity would be sufficient to plug the hole, is an effective public policy strategy.  The danger is that, due to a combination of exclusions and prohibitive pricing, a significant portion of terrorism risk would simply go uninsured.

We take it for granted that, in the wake of any significant terrorist attack, the government will respond, including with buckets of money. Our goal is to try to find that structure that maximizes private sector coverage, if only to make the government response that would otherwise be used to compensate uninsured risks as small as possible.

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