Insurance, Self-Protection, and the Economics of Terrorism

This paper investigates the rationale for public intervention in the terrorism insurance market. It argues that government subsidies for terror insurance are aimed, in part, at discouraging self-protection and limiting the negative externalities associated with self-protection. Cautious self-protective behavior by a target can hurt public goods like national prestige if it is seen as “giving in” to the terrorists, and may increase the loss probabilities faced by others if it encourages terrorists to substitute toward more vulnerable targets. We argue that these externalities distinguish the terrorism insurance market and help to explain why availability problems in this market have engendered much stronger government responses than similar problems in other catastrophe insurance markets. We are grateful to Harold Demsetz, Steven Garber, Dana Goldman, Steven Haider, Jack Hirshleifer, Arie Kapteyn, David Loughran, Jim Poterba, Robert Reville, Seth Seabury, Bill Vogt, and numerous seminar participants at RAND and UCLA for helpful discussion and comments. We thank Priya Gandhi for research assistance. Lakdawalla is grateful for the support of RAND’s Institute for Civil Justice. The views expressed in this paper are those of the authors and do not necessarily reflect the positions of the Federal Reserve Bank of New York, the Federal Reserve System, or RAND. RAND, 1700 Main Street, Santa Monica, CA 90407. [email protected] Capital Markets Function, Federal Reserve Bank of New York, 33 Liberty Street, New York, NY 10045. [email protected]