Yesterday, a bill extending terrorism insurance provided by the U.S. Government passed the Senate by a vote of 93 to 4. The federal government began participating in terrorism insurance markets following the events of September 11, 2001. Under the Terrorism Risk Insurance Act, insurance companies are required to provide terrorism insurance, while the government picks up losses after a large deductible.
The concept of "moral hazard" originated in the insurance industry, but it applies in many financial contexts. Financial market history offers many lessons about the severity of moral hazard problems.
What is moral hazard? Putting it simply, once insured, people may take more risk than they did before they were insured. The insurance world, of course, knows about this possibility, and prices and monitors the insurance it provides.
The insurance world has long made an interesting distinction between “moral” hazard, and “morale” hazard. The moral dimensions of moral hazard can get pretty interesting, and in insurance, moral is distinguished from morale in the sense that, once insured, people may actually have an incentive to cause the loss for which they have purchased insurance.
Moral hazard is sometimes referred to as “the risk of a $10,000 garage rubbing up against a $15,000 fire insurance policy.”
Well, how can this illuminate government terrorism insurance?
Speaking of moral dimensions, here we have a case where the provider of insurance – the government – is also a participant in activities that can spark the risk that it is insuring.
Once they provide insurance, insurance companies book revenue they earn over time. They also establish reserves for future losses, which reside among the liabilities on the balance sheet.
How about the U.S. Government? Does it book a liability for reserves under its terrorism insurance?
No. The financial report of the U.S. Government does not include a calculation of terrorism liability. There is a footnote disclosure that the Terrorism Risk Insurance program exists, but no calculation of the cost of the program.