Why insure?

The issue of terrorism insurance is raising its head again. In the UK, and more so in the USA, the issue of who pays for damages caused by terrorism is being debated. While this may seem to be an esoteric issue, far from the concern of common mortals, this issue cuts deep into what it means for a state and where its responsibilities lie. For us to understand this issue, we need to delve a bit deeper into the background, by seeing how terrorism is considered in the insurance industry, who should bear it, what are the commercial problems related to it, the moral issues and finally the politics of the issue. At end of the day, while sadly the victims of terrorism pay directly with their lives or injuries, every taxpayer and insurance holder pays for terrorism. This WILL affect your pocket, which in many cases might hurt more.

I would posit that most of the readers of this column have some kind of insurance. They may have home insurance, car insurance, they may have insured their pets or their health, some have even insured their legs (although I doubt whether this column will get to that lady concerned). They may be working in a farm and have weather insurance, they may be working in a manufacturing company and the company may have business interruption and director liability insurance, they may be working as plumbers and will have employment insurance or business damage insurance. Essentially, subject to conditions, what it means is that you are trying to protect yourself (and others) from adverse events. If that adverse event happens, then the insurance company will pay you some defined benefits (in cash, in kind or in form of services). So far, so good!

Insurance has a very long history and in many ways, is almost as old as human history itself. Conceptually, insurance is very tightly tied to protection and self-preservation. Back in the good old days where all I had to worry about was to find the nearest water hole and a good succulent mastodon to brain and eat, I would try to insure myself from harm by engaging in many activities which would increase my safety potential, such as having a leader. I will give him first dibs on the meat I kill, so that he protects me from that evil sabre tooth tiger. I am insuring myself, and my premium is the meat and the leader is the insurer. I would pray to the gods to insure that they look after me, grant me health, wealth or luck or for any other purposes, religious or not. This started developing further as the complexity of human life increased. We have evidence that 3000 years ago, there was the concept of crop insurance, where farmers would pay a certain sum of money or a crop share or an amount of labour to middlemen for coverage if disaster strikes such as locusts, droughts, etc. etc. It was quite 'hit and miss', but things improved over the following centuries, until insurance as we know it starting emerging in the past 150 years or so.

We have to also explore the concept of the insurer of last resort. What this means is that somebody will be there to pick up the pieces, even if the insurance companies can't or won't take up a particular type of insurance. In some cases (such as major natural disasters or financial institution failure), governments step in with some kind of a payoff, either in kind or in cash. So for example, in many countries, if a bank fails, the government will pay up "x" amount of cash for every depositor. This is the meaning of the insurer of last resort. But this action is only carried out on very special occasions, but more of this later.

As you can see, there are some things which you cannot expect from any insurance. Take a look at your home insurance policy and see the exclusions, you will see that home insurance is not valid for cases such as war, acts of god or what have you. If you are asking a private company to insure you, they will only insure you, provided they can measure the frequency and severity of the adverse event. Wars and acts of god, by their very definition, cannot be measured in terms of frequency or severity. Insurers try to mitigate their risks by asking for lower car insurance premiums if you have good locks fitted, if you have a tracker device, if your car is not a Rolls Royce, Ferrari Testarrossa or Lamborghini Countach, so on and so forth.

Now let's take a look at terrorism as an adverse event. The problem, which we have, is that this is definitely an adverse event, because the downside is literally infinite, the damage which can occur can potentially be very big and huge, one cannot measure the frequency and it is almost impossible to mitigate against it. For example, a dirty nuclear bomb going off in front of the Bank of England or in Cabot Square in Canary Wharf will mean billions of dollars worth of damage. The 9/11 damage was estimated variously between $10 billion and $40 billion (depending upon what you include and who you ask). One cannot predict nor measure the frequency of these attacks, so nobody can put aside capital for them and finally, just how does one mitigate against terrorist attacks? We cannot.

Putting it in another way, the total capacity of insurance within the UK is estimated to be approximately $100 billion per year. In other words, British Insurers can, if pushed, pay out this amount in claims. In the USA, the capacity is estimated to be $250-300 billion per year. Please bear in mind that this is an all inclusive capacity, including all assets such as car, marine, house, individual, business interruption, pet, etc. insurance. If we do end up having a dirty bomb in the middle of the City of London, I would roughly guess that it is not beyond understanding that the amount of damage claims that the insurers can handle is $50 billion. As one can appreciate, this kind of claim will blow a canary wharf building sized hole in the insurance companies and will basically mean that nobody will be able to get any kind of insurance. So what is the solution? Here comes the insurer of the last resort solution.

Governments stand up and say, ok, you guys, you insure yourself with the insurance companies, if the total amount of claims because of an adverse event is say more than $10 billion, then anything over $10 billion will be paid out by the government. Why? Why? Because the government becomes the insurer of the last resort. The government wants to have a functioning economy, including insurance and it doesn't want to scare people away. The United Kingdom has a policy akin to this and so did the USA (especially after 9/11). After 7/7, the damage, which was estimated to be around $50 million, will be covered by the insurers. After 9/11, the government stepped in and said that they will pay compensation to people and in certain cases, some of the businesses. But now, the USA wants the private sector to take over the entire lot of terrorism insurance. Why is that? Well, I am not privy to their thinking in detail, but I could make some educated guesses.

The first is that this open-ended liability and promise causes financial markets to worry about the exposure of the government. At end of the day, the government doesn't produce money, it either taxes its citizens and companies, or it borrows from the markets. If the threat and incidents of terrorism increases dramatically, then the probability that the government has to pay out increases in the same proportion and thus the risk increases. Therefore, lenders to the government will demand more money in the form of interest rates to lend to the government. So one reason is to protect the economy and reduce the borrowing rate. Second reason is that it could produce a moral hazard. If you know that the government will pick up the pieces, then you will not take steps to protect yourself, such as have security guards, take out personal insurance, be more blasé about exposing yourself to danger, and the same goes for companies as well. So the idea is that if you force the insurance companies to take the load, they will force individuals and companies to try to mitigate the risks.

This brings us to a core political problem, this is something, which has not been discussed openly or even understood properly. One of the primary purposes / objectives of a state is the security / protection of its people and citizens. It is theoretically possible that if we allow the private sector to be solely responsible for terrorist insurance, then there is no logical or moral reason to think that they are not going to have an intelligence network, a counter-terrorism network and even an armed response unit. After all, they have to try to minimise the frequency and severity of terrorist incidents, no? Why would they like to pay large sums of money? I am not saying that this will happen, but if one compares with say car insurance or home insurance, the reason why there are different premiums if you have a Yale lock or a plastic latch is because the chances of theft are lower in the former case, hence the payout is lower. Insurance companies actively work with anti-theft equipment manufacturers and the police to stop theft and to try to reduce their payout.

If this is indeed the case, one does see the possibility of an intelligence network, analysts and counter-terror personnel in the employ of insurance companies, who will be able to advise the company on policies, investigate claims and perhaps even try to take mitigating action themselves.

Now, aren't these activities falling within the purview of the government? To analyse the threat of terrorism, investigate incidents and try to mitigate them by deploying security services, military people and counter-terrorist activities? Furthermore, terrorist actions happen because of certain state policies or to try and blackmail a state into some sort of action, so why shouldn't the state be held accountable to a certain degree? I am not saying that this will happen, but if the government is not the insurer of the last resort and it's a private company who is in charge of your security, then what really is your link to the state? (Incidentally, this is something akin to what the US insurance companies are arguing about as well). What about the implicit bargain that citizens have with their state? I will pay you taxes while you protect me. If you are not going to protect me, why should I pay you taxes? Do you see where I am coming from?

It is an interesting view and one, which USA needs to consider carefully before insisting that the private insurance companies take up the entire load of terrorist insurance. Terrorist events are not going to go away, that is for sure. What one needs to understand is that besides the increase of fear in the citizens, it can also loosen the contract between the state and the citizen.

All this to be taken with a grain of salt!