Knowing the unknowable

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Historians and insurers will both have to re-write their books following the terrorist attacks on America.

The insurance industry is well equipped to deal with natural disasters in the developed world: the hurricanes that regularly hit the south-east of the United States; the earthquakes that are bound to rock Japan and California from time to time. Everyone understands the nature of these risks, and their potential consequences. But we are ignorant of exactly when and where they will materialise. For risks such as these, you can write an insurance policy and assess a premium.

But the three largest disasters for insurers in the last twenty years have been man-made, not natural. The human cost of asbestos was greater even than that of the destruction of the World Trade Center. It was known for a long time that asbestos was nasty stuff – but not how nasty it was. We now understand that even momentary exposure can cause cancer decades later. The deluge of asbestos related claims was the largest factor in bringing the Lloyds insurance market to its knees.

If asbestos was tragedy, savings and loans was a farce. In 1982, Congress deregulated American mortgage banks. The hope was that they could recover through speculation in property and financial markets what they had lost through the interest rate of Paul Volcker, then Federal Reserve chairman. This proved an irresistible invitation to criminals and incompetents. The economic losses were as large as the costs of last month’s terrorism.

These three incidents could hardly be more different. And therein lies the problem. Their common feature is not simply that no-one foresaw these specific events – no-one anticipated the Kobe earthquake either. It is that no-one foresaw events of these kinds. This ignorance of the very existence of the risk differentiates these man-made disasters from predictable natural ones. The range and complexity of modern life is now so great as to challenge the ability of our institutions to manage the associated but unknowable risks.

When a predictable disaster happens, it is relatively clear who is responsible for payment, because all the parties are prepared for such a contingency. But this can never be true for the unforeseen disaster. It is thus essential that the US government brokers a settlement of who gets what, and who pays what, as a result of the World Trade Center collapse. The airline bailout includes preliminary recognition that this is necessary. If the government does not intervene, then the solidarity which brought everyone together in the aftermath of the tragedy will collapse in a welter of legal argument. The experience of asbestos – where costly and seemingly unending legal processes bring very little benefit to individual victims – is a stark warning of how things can go wrong. The establishment of the Resolution Trust Corporation to sort out the consequences of the savings and loans fiasco was a better precedent.

The noise of stable doors slamming behind bolted horses is deafening today. The insurance industry will move to ensure that it is not exposed to this particular risk again. It has rewritten policies in an attempt to limit liability for problems, such as asbestos, where the effects may remain hidden for many years. In the financial services industry, the search for market solutions to default risk ended much earlier when the American banking system came close to collapse in 1933. And so the largest insurer to be hit by savings and loans losses was FSLIC, an agency of the US government.

In this way, as insurers restrict the range of risks they cover, the government moves in to fill some of the gaps. Terrorist risk for prominent buildings in London was already underwritten by the British government. Similar arrangements were hastily brought in around the world last month to keep airlines operating. Such government involvement will extend to other business lines as insurance exclusions are extended on renewal.

But companies and individuals will find themselves increasingly on their own. Cigarette smoking and AIDS are equal calamities. But the economic and social costs have fallen mostly on public health systems and the sufferers themselves. The share borne by the insurance industry has been relatively modest. Global warming is the main prospective man-made disaster we know about, and its costs too – building flood defences and changing the patterns of agriculture – will mostly be borne by governments and affected businesses.

All this offers a bleak outlook for general insurance business. From time to time, the industry will be hit by events that were not envisaged when policies were written and for which the industry cannot have been paid in advance. At the same time, the category of risks the industry can cover will be steadily eroded, through its own exclusions, and through scientific advances that turn seemingly random occurrences – such as the onset of disease or the incidence of extreme weather – into predictable ones. The role of traditional insurance markets in managing the risks of the natural and economic environment will steadily decline.

As the market bows out the socialisation of risk will increase. Extended involvement of government in the economic consequences of disasters is inevitable. We may look at the continental European model, where huge reinsurers effectively provide risk management expertise and manage large reserves on behalf of society as a whole. It is ironic that Warren Buffett’s Berkshire Hathaway proves to be the largest American reinsurer of the World Trade Center. Who better to manage risk for the United States of America?

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