Political Economy: Trial Lawyers and Terrorism Insurance

As the preferred client of the Democratic Party, the plaintiff’s bar has vetoed any terrorism insurance legislation that does not allow for punitive damage awards. Its obstinacy has angered many Republicans and the business community writ large, which believe federally-backed terrorism reinsurance would be a tonic to the weak economy. Last week, President Bush demanded that Congress come together to reach a compromise and blamed trial lawyers for the impasse, quoting typical anti-plaintiff sloganeering, including a suggestion that trial lawyers “have never seen a disaster that didn’t justify a lawsuit.”

The American tort system is a mess largely due to the influence and manipulation of trial lawyers, who are less interested in seeking justice for injured clients than punitive damage bonanzas for themselves. But with Congress poised to shower billions on the insurance industry, who can blame the trial lawyers for demanding a cut?

Since the start of this year, reinsurance rates – the premiums direct property and casualty insurance companies pay to insure themselves – have hardened dramatically. Businesses seeking to purchase terrorism insurance for commercial properties face coverage limits and premiums between 20 percent and 100 percent higher than a year ago. Some real estate firms with “trophy properties” cannot get any coverage at all.

As a result, businesses and primary insurers have turned to “alternative risk transfer,” a phrase used to describe financial strategies to address risk without traditional insurance policies. These strategies include securitizations, where risk is packaged and sold to investors as bonds, contingent capital plans, where banks offer emergency credit lines to customers, and more traditional self-insurance strategies such as captives, where companies set up their own insurance affiliate and sell equity and bonds to raise capital.

The insurance market is like others in the sense that when insurance is cheap, consumers buy a lot of it, but when insurers retrench and prices rise, businesses look for other ways to address risk. And with equities reeling, repackaged risk has become popular for investors seeking to diversify their portfolios with assets not linked to the stock market.

While precise models for terrorism risk do not exist, the framework for the securitization of the underlying risk is already in place. Today, businesses are able to use derivative products to hedge against the cost of inputs such as oil, changes in exchange rates, and default risk. These risks are all within the purview of traditional insurance, but the financial markets naturally developed in ways that allowed businesses and banks to repackage risk in more dynamic and affordable ways.

While terrorism poses risks that are difficult to measure, today’s international risk architecture provides the means to manage the knowable risks effectively enough to prevent dislocation. With between $100 and $300 billion in reserves, the worldwide insurance industry may not have the capital to take on the incalculable risk of terrorism, but if that risk is repackaged and sold to numerous investors in an $8 to $12 trillion financial market, it becomes manageable. Last month, Charlie Cantlay, deputy chairman of Aon’s UK reinsurance group, said “the major corrections in rating and coverage have already occurred” for reinsurance following September 11 and “any further increases will be constrained and in all probability at the lower end of client expectation.”

The migration of risk transfer from the walled-off world of insurance to the broader capital market is a natural development that presents great opportunities for corporations seeking to transfer risk, financial services firms able to dilute and repackage that risk, and investors eager to diversify their portfolios with new asset classes. To create a federal reinsurance backstop would artificially prop-up the traditional insurance model at a time when new risk management techniques provide the greatest hope for the efficient allocation of terrorism risk.

When the Bush administration works to subvert the market’s natural digestion of risk to benefit certain constituencies at the expense of others, it invites other interest groups to lobby their political brokers for similar benefits. If the trial lawyers successfully block a federal hand-out if they do not get one of their own, for once taxpayers and consumers will be better off for them.