The Economic Effects of Federal Participation in Terrorism Risk

ABSTRACT The catastrophic terrorist attack of September 11, 2001 caused unprecedented insured losses. While the insurance industry covered these losses, it also took swift steps to limit its exposure to such risks in the future. In response to ensuing market dislocations, the Terrorism Risk Insurance Act (TRIA) was passed in 2002. The law temporarily requires primary insurers to offer terrorism coverage and creates a federal "backstop" to limit losses on such coverage. In anticipation of the program's scheduled expiration, and to inform debate on its possible extension, this article analyzes market developments in the wake of 9/11 and the passage of TRIA. We find that to date, TRIA has facilitated private sector participation in the market for terrorism insurance by lending structure to an otherwise ill-defined risk. While alternative terrorism risk bearing mechanisms are evolving, none appear ready to replace federal involvement presently. We conclude that a continuation of TRIA for a period of time would enhance U.S. economic performance in the near term. Failing to extend TRIA in the near term would result in decreased economic performance absent another major terrorist attack and greater instability, job loss, and bankruptcy in the event of another attack. INTRODUCTION The catastrophic terrorist attack of September 11, 2001 fundamentally changed the way the world looks at risk-and changed the insurance industry-forever. Insured losses were more than one and a half times as large as the next largest insured catastrophe loss in history, and more than 30 times larger than the next largest insured terrorist loss.1 On a prospective basis, the United States' vulnerability to international terrorism took on new and troubling dimensions. The new economic reality is that terrorism losses require time to develop private sector capacity for risk management. While the insurance industry initially covered 9/11 losses, it also took swift steps to limit its exposure to such risk in the future. Following 9/11, many reinsurers promptly stopped covering terrorism risk in new or renewed contracts. Primary insurers in turn sought to exclude terrorism risk from their polices and began aggressively managing their exposure to such risk. By August 2002, regulators in 45 states, the District of Columbia, and Puerto Rico were permitting insurers to exclude terrorism coverage from most types of commercial property and casualty coverage. Despite these aggressive risk management measures, many insurers still felt overexposed to terrorism risk. The five states that did not approve terrorism exclusions-California, Florida, Georgia, New York, and Texas-account for roughly 36 percent of U.S. insurance premiums.2 Even in states that did approve exclusions, the exclusions did not apply to workers' compensation insurance or fire following a terrorism event in the 28 states with standard fire policy laws. The 9/11 tragedy thus triggered ongoing dislocations in the marketplace. In many states, businesses were unable to obtain adequate terrorism insurance and were being forced to bear all the risk of catastrophic terrorism losses except for workers' compensation claims themselves. In other states, primary insurers were being forced to bear an uncomfortably high share of terrorism risk and/or curtail all-risk policy offerings due to a lack of available and affordable reinsurance. In response to these market conditions, the Terrorism Risk Insurance Act (TRIA) was signed into law on November 26, 2002. The program, which requires primary insurers to offer terrorism coverage in commercial property and casualty insurance policies and requires the federal government to pay 90 percent of insured losses net of insurer deductibles, is currently set to expire at the end of 2005. In anticipation of TRIA's expiration, and to inform debate on its possible extension, this article analyzes market developments in the wake of 9/11 and the passage of TRIA, focusing on whether markets have evolved to the point where they can bear terrorism risk more efficiently with or without continued government involvement. …