Prof. Anne Gron

The terrorist attacks of Sept. 11, 2001, jarred many sectors, but perhaps none more so than the insurance industry.

Faced with $40 billion or more in claims, insurers reacted swiftly to the increased uncertainty and reduced capital within the industry. They canceled airlines’ war-and-terrorism coverage and began to exclude acts of terrorism from commercial policies up for renewal.

These decisions have put airlines and property owners at odds with creditors and regulators, creating additional uncertainty in an already swooning economy. Soon after Sept. 11, the Bush administration arranged for airline coverage through the Federal Aviation Administration. This coverage is required by most airports, and limits the liability of the insurers.

Government action to relieve the problems for other sectors did not occur until November 2002, when Congress passed the Terrorism Risk Insurance Act. The law provides a three-year “backstop,” during which the government will pay up to 90 percent of up to $100 billion in damages from a large-scale terrorist attack. After that, coverage reverts to the insurance industry.

Many insurance buyers breathed a sigh of relief at these developments. But Anne Gron, a Kellogg School professor of management and strategy, argues that the government’s move may cause more harm than good.

In a recent article in Regulation magazine, Gron and co-researcher Alan O. Sykes of the University of Chicago Law School, argue the insurance industry was largely capable of recovering on its own — just as it has from other crises. However, as with other large loss events such as natural catastrophes, capacity to cover the largest events may not return. Gron and Sykes argue that past experience with government insurance programs weighs against long-term intervention to supply insurance for these events.

They contend that insurance crises are part of a larger pattern of pricing and availability in insurance markets, and not a cause for the government to get into the insurance business.

Gron, who has studied the industry for 15 years, says the insurance industry reacted similarly after Hurricane Andrew in 1992, the Northridge earthquake in 1994 and the boom in liability lawsuits in the 1980s. All caused large unanticipated losses for insurers.

Insurance crises, marked by increasing prices, reduced limits, and, sometimes, the exit of insurers from markets, followed each of these events.

These changes reflect the significant loss of capital and the continuing exposure of insurers to these risks through existing policies. High prices reflect both higher expected losses and temporary capacity shortages for these risks, Gron notes. Higher returns to scarce capital help increase insurance capacity directly and attract new capital to the industry.

As capital increases and insurers’ inventory of exposures fall, prices decline and availability increases. In a typical cycle, prices continue to fall and a soft market ensues with relatively low insurer profits. The soft market persists until another large, unanticipated loss reduces capacity enough to trigger another crisis.

While crises are part of the adjustment to capital shortages, they cause real problems for policyholders. Faced with rapidly increasing premiums, policyholders must decide whether to pay higher costs or bear the risks themselves. During the 1980s liability crisis, a few manufacturers chose to withdraw products instead.

Owners of commercial real estate are particularly affected by the current lack of terrorism insurance. In some cases, lenders have required owners to purchase expensive coverage. In other cases, where insurance is unavailable, lenders and owners bear the risk.

Still, Gron and Sykes assert that conditions are likely to improve with time, just as they have after past insurance crises.

The greater danger, they say, is that the government’s involvement could undermine the insurance industry as a whole through inexpensive but poorly managed coverage.