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Article Excerpt
Introduction
When terrorists commandeered four commercial aircraft and converted the planes into kamikaze weapons on September 11, 2001, the airline industry was plunged into a very serious financial crisis and the public airspace was severely diminished in value. The terrorist attacks dramatically affected the flow of capital to and from the airline industry. Essentially there was an outflow of private capital and inflow of public capital. The insurance industry pulled capital out of the aviation market by increasing premiums, lowering coverage, reducing required notice of cancellation, and canceling existing policies and not underwriting new polices. Investors sold off the equity and liabilities of airlines, passengers canceled flights and reduced future bookings. Existing aircraft were grounded and orders for new aircraft were canceled. The federal government stepped in to replace the private capital that flowed out of the aviation industry. On September 22, 2001 only ten days after the attacks, the 107th Congress passed the Air Transportation Safety and System Stabilization Act (Pub. L. No. 107-42, September 22, 2001). This act made $10 billion of subsided federal credit instruments available to air carriers and $5 billion in compensation available to air carriers. This act also authorized the Secretary of Transportation to insure and reinsure aircraft operating in U.S. airspace, reimburse air carriers for increases in the cost of insurance in the aftermath of the terrorist attacks of 9/11, and established a victim compensation fund administered by the U.S. Attorney General. The same Congress on November 19, 2001 passed the Aviation and Transportation Security Act (Pub. L. No. 107-71). This act created the Transportation Security Administration (TSA) within the Department of Transportation to be administered by the Under Secretary of Transportation for Security. This act placed limitations on the liabilities faced by air carriers as a result of the acts of terror on 9/11. One of the actions of the Aviation and Transportation Security Act was the federalization of passenger screening at airports. The Federal Homeland Security Act of 2002 (Pub. L. No. 107-296--November 25, 2002) gives air carriers access to war risk insurance supplied by the federal government that covers aircraft hull, passenger and third parties. (1) While the provision for this Federal insurance of aircraft has been extended multiple times since its original expiration date on August 31, 2003, it is currently set to expire August 31, 2007. By placing public capital at risk ahead of private capital, the Government is able to keep private insurance capital flowing to the aviation industry.
When the TSA took over the responsibility of passenger screening from the private sector, public capital was substituted for private capital. (2) Immediately after the terrorist attacks, the Federal Aviation Administration (FAA) grounded all commercial airline flights until September 14. One dimension of the financial crisis was the result of reduced demand for air travel; the other was increased operating costs resulting from tougher security measures and higher insurance premiums.
The government expanded its role in the security area by federalizing the function of screening passengers. The Registered Traveler (RT) program that we examine in this paper is a step in the other direction. The RT program is a public-private partnership where the private sector builds, owns and operates a dimension of the passenger security screening process at U.S. airports.
The objective of the RT program is to separate the traveling population into those who have been prescreened and registered as "trusted travelers" and those who have not been registered and who therefore have not been designated as trusted travelers. The short-term public benefits of the RT program should grow from the ability of the federal government to more efficiently allocate resources to passenger screening, smaller haystack larger needle. Longer term public benefits should stem from the success of the program in reducing the risk of terrorism to passenger and aircraft. If the program measurably reduces these risks then the federal government's exposure to these risks will be reduced and the private sector should be willing to offer insurance at rates that reflect the increased security. If the benefits of the program in terms of risk reduction can not be measured, this latter benefit may not materialize. We emphasize that the RT program is only one dimension in the spectrum of security procedures and programs that are being implemented to reduce terrorist risk to the aviation industry, and it may not be possible to accurately measure the risk reduction offered by the RT program.
Once the federal government reduces or phases out its financial support for the airline industry, the pressures of insurance costs will again erode the financial performance of airlines unless insurers can expand their sources of capital or are convinced that the risk to aircraft and passengers has been reduced to acceptable levels.
Spreading the risk of terrorist acts across a broader capital base via the securitization is one avenue that is being explored by financial economists and financiers, (see Smetters, 2005). Securitization is a way of redistributing terrorism risk to different parties. One line of research focuses on how financial losses can be more efficiently distributed after an act of terrorism takes place, (Cummins & Lewis, 2003; Kunreuther & Michel-Kerjan, 2004). A second avenue of research examines how to finance solutions that reduce the likelihood of a terrorist attack (see Viscusi & Zeckhauser, 2003, 2005). The general consent is that both public and private sectors should financially participate to the costs associated with the reduction of terrorism (see Brown, 2004; Brown, Cummins, Lewis, & Wei, 2004). One measure of the effectiveness of the RT program would be the willingness of insurance companies to lower their rates on aircraft insurance to airlines that participate in it. If the program actually increases security, airlines should be able to offset some of their insurance costs by illustrating this enhanced security to insurance firms just like individuals who participate in certain preventive health programs can reduce their health insurance premiums.
Our paper is about an aviation security program. Enhanced security can make insurance markets more efficient, and insurance markets can increase the flow of capital into projects to enhance security. The RT program is designed to reduce the risk that a terrorist can board an aircraft. Insurance of damages caused by terrorism creates incentives for the underwriter to prevent terrorist acts that will cause claims and the prevention of terrorism through enhanced security reduces the value of capital at risk. If the RT program offers value in terms of a measurable reduction in the likelihood of an airplane or airport being attacked, then the insurance and reinsurance companies that underwrite aviation insurance should recognize the enhanced security of the assets. The recognition should come in the form of monetary compensation. After the attacks of 9/11 the market for insurance of aviation assets froze up. Without insurance, airlines could not fly. As private capital fled, the Federal Government stepped in to fill the void. Robert Rhee (2006) discusses the role that capital markets can play in financing and distributing risks associated with terrorism. Rhee (2005) also examines the potential for and current constraints to distributing terrorist risk to the capital markets by means of securitization. He addresses how financial innovation can make the market for terrorism insurance deeper and more liquid, and the current constraints that may delay innovations.
Boin and Smith (2006) discuss how the public and private sector should pool their resources to protect critical infrastructure against terrorists.
A May 2002 study by the Joint Economic Committee of the United States Congress, Economic Perspectives of Terrorism Insurance, chaired by Jim Saxton and authored by Senior Economist Dan Miller, analyzes the value of insurance against damage caused by terrorism to industry and how the limited market for terrorism insurance affects economic activity.
Evans, Garcia-Swartz, and Layne-Farrar (2006) analyze progression of academic thought on the market for terrorism insurance and the ideas concerning the appropriate role for government in this market. They review the reaction of the President and Congress in the United States in aftermath of the 9/11, particularly the passage of the Terrorism Risk Insurance Act in 2002. While they do no use the term, their analysis evokes an interesting role for the government, a role they conclude was effective after 9/11 and one they see as an important element that keeps the private market for terrorism insurance liquid. The federal government is effective as the insurer and reinsurer of last resort. This terminology can be found in the paper by Levmore and Logue (2003). They analyze how government intervention in the risk insurance markets will effect expectations of insurers and insured and alter the pricing and supply of insurance that covers damages caused by acts of terror.
It is critical that the correct balance between public capital and private capital is established so that insurance industry does not receive a permanent subsidy from the government, which would distort the pricing of terrorism risk. This would not help in the accurate measurement of risks associated with terrorism and would then make it more difficult to measure the effectiveness of security programs.
Because property owners are required to carry terrorism insurance, the demand for the product is increasing. For a well-functioning and growing economy it is now imperative that the supply of this type of insurance is continuously available. Schmalensee (2006) analyzes how innovation in this market, and government support of making innovation more likely, is critical to increasing the supply of terrorism insurance.
The fundamental issues we...
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