Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [85]
The calls for government catastrophe insurance always emphasize the negative ripple effects that would arise in the absence of an insurance market to provide financial protection. For example when terrorism insurance became unavailable after the 9/11 attacks, there was widespread concern that construction and mortgage lending would stop at least in the urban areas. The 9/11 experience, however, also provides a caution. The Terrorism Risk Insurance Act (TRIA), which established the arrangement between private insurers and federal government to cover commercial firms in the United States against terrorism, was not signed until November 2002—more than fourteen months after 9/11. Contrary to the industry’s alarmist threats, real estate and mortgage activity continued at what could be considered the normal rate conditional on the slower economic growth that occurred in the overall economy.
While all the government catastrophe insurance programs have served their primary goal of providing insurance in the absence of private market alternatives, two key problems remain evident:
• Limited Risk-Based Pricing and Subsidized Insurance. Governments generally fail to impose meaningful risk-based insurance premiums, even when the programs technically require an actuarial basis. Since the higher risks are underpriced, this failure to use risk-based pricing creates a subsidy. It also removes the economic incentive for those who are exposed to properly invest in risk reduction measures. In the worst cases, the government is actively encouraging people to put their homes and commercial structures in harm’s way, since the cost of government insurance makes little or no distinction among locations or risk mitigating activities.
• Crowding Out of Private Markets. None of the private insurance markets have recovered in any substantial way once the government insurance plan was created, which is not surprising in view of the subsidies that are provided.
Lesson 4: Public-Private Insurance Partnerships Can Be Attractive
This lesson can be illustrated by reference to the TRIA legislation, first passed in November 2002 to provide federal reinsurance for qualifying losses from a terrorist attack. Since TRIA provides a useful starting point for developing government reinsurance plans to cover financial catastrophes, I provide a summary of its key and relevant features below.4
• Industry Loss Trigger. The government’s terrorism reinsurance is triggered only when the industry’s aggregate losses for a qualifying terrorist attack exceed a specific amount (currently $100 million).
• Government Excess of Loss Coverage. Each insurer has a deductible amount as a percentage of its premiums written for commercial property and casualty insurance. The insurer must pay all losses up to this deductible, and must also pay co-insurance (15 percent) for the losses above this deductible (to an event limit of $100 billion).5 The deductible and co-insurance have the effect that private insurers will receive little or no government reimbursement except for the largest terrorist attacks. This leaves insurers with a strong incentive to use risk-based pricing and to induce property owners to take action to mitigate the risks where possible. The government’s reinsurance, however, is provided without charge and thus the overall program does retain an element of subsidy; the subsidy offsets the incentive for property owners to mitigate their risks.
• The “Make Available” Requirement. This legislation requires that all property and casualty insurers continue to “make available” terrorism coverage on the same conditions (but not at the same prices) they offered prior to 9/11.6 Perhaps surprisingly, the result has been a well-functioning and reasonably priced market