Moral Hazard Lights Flare Around Bailouts

Some say too much government help will make the insurance situation worse.
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While the events of Sept. 11 left several big holes in the U.S. economy, some question the wisdom of refilling them with government aid.

Congress is currently debating a bill under which the U.S. government would help the insurance industry cover losses due to terrorist acts over the next two years or more. The airline industry already won $15 billion from the government in September.

Critics contend that government bailouts inevitably snowball, and that aid programs often make industry weaknesses worse. The insurance package, for instance, could delay the creation of good terrorism coverage policies, hide the costs of new risks, and put off debate over needed changes in legislation, they say.

"Once the government is the ultimate safety net, it discourages the normal workings of the marketplace," said Marshall Wittman, senior fellow at the Hudson Institute, a conservative think tank in Washington. "A number of industries are trying to take advantage of extraordinary times, to get aid that runs counter to market principles. It creates a dangerous precedent and underscores the old moral hazard problem," he said.

The insurance aid package will probably be stuck in Congress for at least another three weeks, but the current proposal under discussion in the Senate would require insurance companies to cover the first $10 billion of terrorism-related losses in 2002. Taxpayer money would be used to cover half of the next $10 billion and 90% of any losses above $20 billion. The following year, those sums would double to $20 billion and $40 billion. After that, the government could end or extend the program.

Undermining Underwriting

Without some way of measuring the risk, it is difficult to underwrite and price a product, says Julie Rochman, senior vice president at the American Insurance Association, a Washington-based trade group. "Traditional loss-control measures don't apply. Terrorists are looking to inflict maximum harm," she said. At least in the beginning, the higher the deductible assigned to the industry by the government, the higher the premiums for terrorism coverage will be, she said.

Insurers and reinsurers plan to cover the cost of Sept. 11, estimated at $40 billion to $50 billion, in full. But reinsurers, which back up insurers when damages are extraordinary and are footing about two-thirds of that bill, have said they won't include terrorism coverage in contract renewals at year-end. Separate contracts for terrorism reinsurance will have to be drawn up. In order to keep premiums from skyrocketing during an economic slump, insurance companies say they need a couple of years to work out a reasonable reinsurance plan, as the risks of terrorism are so difficult to calculate.

Analysts note that the industry has responded well to unknown risks before, however. "The response after Hurricane Andrew showed how markets react to risk," says Matt Mojer, an analyst at A.M. Best, a rating agency for the insurance industry. "They generated a tremendous amount of capital and put greater importance into modeling hurricane risk," he said. Hurricane risk is much more easily modeled than terrorism, however, because of the historical data available. "But models need to be created for terrorism," he said.

The industry will probably have to hike insurance premiums anyway, since the $10 billion lump sum in the current proposal doesn't address individual companies' exposure to terrorism risk. Mojer said he expects premiums would jump at least 5% to 10% in commercialized insurance, but that they could rise as much as 20% to 30%.

Market distortions could also be created by the government aid package. "If the real risks of locating tall buildings in big cities is greater, you don't want to hide that risk," said Peter Van Doren of the Cato Institute, a conservative think tank. "These proposals say, Keep doing everything like you used to," he said. Safety standards have been set by the insurance industry for a long time. The prohibitive cost of insurance for high risk has, in some cases, forced the disappearance of unsafe products like the Suzuki Sidekick, noted Ronald Utt, senior research fellow at the Heritage Foundation.

There is also the question of whether an aid package would delay legislation that might have helped resolve this kind of industry problem in the first place. For the past three to four years, Congress has been debating cuts to capital gains taxes on insurance reserves, as part of a larger catastrophic insurance reform package. Current capital gains taxes are seen as prohibitive for the creation of large amounts of reserves, which can allow companies to cover bigger hazards.

Capitol Herd

As Congress debates the insurance package, dozens of industries are lining up on Capitol Hill, looking for cash to cushion the blow of Sept. 11. And each of them has constituencies in Congress that will want to provide that support.

The farming industry, commodities industries, the national transportation system, the tourism and travel industries, and even the public housing industry have their collective hands out, according to Washington observers.

"The question is how big is the government bank account. As coalitions are built for one industry, there will be quid pro quo, and that is a reckless dynamic," said Clemons. And with future terrorist attacks potentially on the horizon, the bailout cycle could start all over if they strike again, he warns.