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Insurance Against Terrorism

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Insurance Against Terrorism

An alternative to unlimited liability for taxpayers

After hijackers destroyed the World Trade Center on 9/11, taxpayers
ended up spending a lot of money to aid the injured, rebuild public
infrastructure, improve security, and help the jobless. But the private
firms with property and workers in lower Manhattan fell back on their
private insurers. And the companies paid out: Over $35 billion flowed
from their capital reserves to people harmed in the attack. No insurers
went under as a result of 9/11 and all but a handful of claims were
paid within a few months. In short, it was a shining hour for the
insurance industry.

But if another major terrorist attack takes place, the industry
won't have as much need to step up to the plate. Instead, the
government will take charge. Under an obscure but potentially
budget-busting program-terrorism risk insurance-the federal government
has assumed nearly unlimited liability for major terrorism losses. The
program, called TRIA, can claim broad support but has deep flaws and
imposes billions in liabilities on taxpayers. The program, though never
intended to be permanent, will be entrenched before long. Still, it's
not too late to restore an affordable, private system of insurance.

Under the current program, once industry-wide private commercial and
workers compensation insurance claims from a terrorist attack exceed
$27.5 billion, TRIA kicks in and covers the remaining expenses up to
$100 billion. (Congress would almost certainly lift the $100 billion
cap if claims exceeded that amount.) In theory, the money to pay claims
would come from a tax (up to 3 percent) on just about every eligible
insurance policy in the country. If this tax proved insufficient,
Congress would have to use other revenues.

Although TRIA was created in 2002 as a post-9/11 stopgap, insurance
companies have shown almost no interest in replacing it. Often
fractious industry groups representing brokers, insurers, reinsurers,
and commercial insurance consumers have lined up in support of the
program. And, when the Government Accountability Office studied
terrorism insurance earlier this year, it found that the chances of a
private terrorism insurance market developing were very slight. TRIA is
currently authorized through 2014.

And that's a problem because the federal government-already
stretched with bailouts and "stimulus" spending-has no business running
a hugely expensive insurance program. Its record isn't encouraging. The
other major federal effort at disaster insurance, the National Flood
Insurance program, owes the Treasury about $19 billion, has no way to
pay it back, and has actually increased the nation's susceptibility to
flood by effectively subsidizing building in flood-prone areas. States
like Florida that attempt to run property insurance programs have done
even worse.

But that doesn't mean that doing away with federal terrorism
insurance will be easy. The insurance industry has a good reason to
support it. The current system for writing insurance really can't deal
with terrorism adequately.

Explaining why this is so requires some background on how insurers
manage risk. To write a policy, an insurer will build a group of
similar risks-a pool-unlikely to experience losses at exactly the same
time. An insurance company might calculate that the chances of a
$100,000 house burning down during a given year were 1 in 100. It could
then write policies for 100 homes in different neighborhoods worth
$100,000 each and charge a yearly premium of $1,200 for each policy. Of
the $1,200 collected, $1,000 would cover expected claims and the extra
$200 would cover the expenses of writing the policy, provide for the
purchase of reinsurance (insurance for insurance companies), build
reserves, provide return on capital for company owners, and offer a
margin of safety for the insurers' own uncertainty about its "1 in 100
chance" calculation.

But the actuaries who do these calculations can't make decent
guesses about the likelihood of terrorist attacks. The past two decades
have seen only three significant terrorist attacks on American soil.
For every obvious target (like the World Trade Center), terrorists have
picked a less-obvious one (such as Oklahoma City's Murrah federal
building). The best information about terrorist risks, furthermore,
remains a closely guarded secret within the intelligence and law
enforcement communities. Before 9/11, large commercial insurers and
reinsurers generally provided terrorism coverage nonetheless.

It's easy to see why they stopped. Based on existing data on the
number of modern attacks on office buildings and the number of office
buildings in the United States, actuaries forced to make the
calculation might guess that the average yearly chance of a terrorist
attack on a $25 million office tower located in a midsized city, is one
in a million. This would indicate an "actuarial" yearly premium in the
neighborhood of $25 for $25 million of coverage. But no insurance
company with competent management would ever risk $25 million in
capital for a premium of $25 or even $2,500. Even if an insurer decided
to sell terrorism insurance at a price like that, state insurance
regulators would likely block the sale as too risky to the company's
other business. Insurance priced high enough to satisfy regulators and
insurance company managers, on the other hand, probably wouldn't find
any buyers.

Clive Tobin, the CEO of the Bermuda/London reinsurer Torus and a
longtime reinsurance executive has floated another plan in comments at
trade conferences: true reciprocity. Under a "true reciprocal" system,
25 firms that each own a $25 million office building would each take
responsibility for paying $1 million if terrorists destroyed any group
member's building. The firms would pay no yearly premiums in return for
the coverage (they might pay administration fees and exchange $1
payments to make the contracts between themselves legal) and would not
be regulated as insurers. Instead, they would simply pledge their full
faith and credit to pay the claim if another group member experienced
an attack. "What you are really looking for is an agreement," says
Tobin, "to avoid an insured having to tell their board that their
location has just been destroyed and they have no insurance."

The idea, as Tobin conceives it, could have some other wrinkles. For
example, a company that owns a building in Manhattan might take on $50
million of risk for a Minneapolis-based company in return for the
Minneapolis company taking on $10 million in Manhattan risk. Some sort
of formal exchange, very likely, would have to exist to match
participants' risks.

However it works out in practice, the idea has enormous potential
benefits. Neither insurers nor insurance purchasers would have to
divert any capital to buy expensive insurance policies against the
unlikely possibility of terrorist attack but, simply by expanding the
size of the groups they joined, could reduce their liabilities.
Taxpayers would owe nothing. (Tobin suggests a secondary backstop that
would have the government provide partial coverage against a specific
company's default on its reciprocal obligations.)

And the idea isn't new. In fact, many existing mutual insurance
companies like Ohio's Westfield Group and San Antonio-based USAA
started writing farm and automobile insurance exactly this way and
sometimes retain a few legal structures of reciprocity. The idea faded
from practice as an insurance company that charges premiums in advance
has a much easier time making payments on claims and can generate more
profits by investing premium dollars between claims. If it doesn't suit
most types of modern insurance, however, such a structure seems almost
ideal for an entity providing sizeable commercial enterprises with
coverage against rare terrorist attacks.

Current law, however, makes it almost impossible to set up such a
structure. "The major [problem] for me is how to make sure this process
can be executed in an appropriate legal and regulatory framework, but
keep this at a light touch," Tobin told me. Since each state regulates
insurance individually, at least some would likely demand that every
party participating in a reciprocal system submit to regulation as an
insurance company. And noninsurance firms would never agree to that.

Risk retention groups, a class of lightly regulated federally
authorized insurance companies that focus on malpractice coverage and
backing for consumer product repair insurance, have something in common
with Tobin's idea but do typically charge annual premiums and face all
sorts of restrictions likely inappropriate to Tobin's idea. Just as
important, the apparently permanent existence of TRIA and the lack of a
real potential for profit in its absence makes it unattractive for
anybody (even Tobin's own company) to spend lots of resources pushing
an alternative.

Making an alternative to TRIA work will probably require special
legislation in Congress. Given the uncertainties, furthermore, it would
be unwise to repeal TRIA before reciprocal terrorism insurance
arrangements get off the ground. Piloting the idea alongside TRIA,
particularly by starting in areas unlikely to experience terrorist
attack, could provide an important proof of concept.

The idea needs further refinement. But it's well worth considering.
Replacing TRIA with a private system won't be easy. But leaving TRIA in
place sticks the American taxpayer with nearly limitless liability for
the coverage of private property. If the government would only
facilitate its emergence, however, it seems that a private solution
could be found to pay the bills for terrorist attacks.