After hijackers destroyed the World Trade Center on 9/11, taxpayers ended up spending many billions of dollars to aid the injured, rebuild public infrastructure, improve security, and help the jobless.
Private firms with property and workers in lower Manhattan, however, fell back on their private insurers. And the companies paid out: More than $35 billion flowed 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 were to take place, the industry wouldn’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 Terrorism Risk Insurance Act (TRIA) can claim broad support but has deep flaws and imposes billions of dollars in liabilities on taxpayers.
Big New Tax Possible
Under the program signed into law in 2002 by President George W. Bush, 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 almost certainly would 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. TRIA is currently authorized through 2014.
Doing away with federal terrorism insurance would not 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.
To write a policy, an insurer builds a group of similar risks—a pool—unlikely to experience losses at exactly the same time. The company might calculate the chances of a $100,000 house burning down during a given year are 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 insurer’s own uncertainty about its “1 in 100 chance” calculation.
Difficulties Setting Premiums
Insurers have stopped offering terrorism policies, and it’s easy to see why. They can’t make accurate guesses about the likelihood of terrorist attacks. Actuaries forced to make the calculation might estimate the average yearly chance of a terrorist attack on a $25 million office tower located in a midsized city as one in a million. 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 such a price, state insurance regulators would probably block it as too risky.
Insurance priced high enough to satisfy regulators and insurance company managers, on the other hand, probably wouldn’t find any buyers.
Clive Tobin, 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 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.
The idea, as Tobin conceives it, could have some 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 be put in place to match participants’ risks.
Huge Potential Benefits
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 a terrorist attack, and they could reduce their liabilities simply by expanding the size of the groups they joined. Taxpayers would owe nothing.
Current law, however, makes it almost impossible to set up such a structure. Since each state regulates insurance individually, at least some would likely demand every party participating in a reciprocal system submit to regulation as an insurance company. Noninsurance firms would never agree to that.
Creating a working alternative to TRIA will probably require special legislation in Congress. Piloting the idea alongside TRIA, particularly by starting in areas unlikely to experience terrorist attack, could provide an important proof of the concept.
Eli Lehrer ([email protected]) is director of the Competitive Enterprise Institute’s Center for Risk, Regulation, and Markets. An earlier version of this article was published in The Weekly Standard. Used with permission.