Insuring Against Terrorism: The Policy Challenge Kent Smetters* The Wharton School and NBER This Draft: February 2, 2004 http://irm.wharton.upenn.edu/WP-Insuring-Smetters.pdf Chapter in Brookings-Wharton Papers on Financial Services: 2004, ed. Robert E. Litan and Richard Herring, Brookings Institution Press, September 2004. Pages 41-42 of 18522 word chapter, On Page 171 out of 450 of book. Asymmetric Information Another potential argument for the government provision of terrorism insurance is that it has more access to sensitive information relative to the private sector. This superior information might allow the government to more-accurately assign prices for reinsurance than a private market reinsurer. Moreover, since the government plays a unique role in mitigating terrorist risks, a government-subsidized backdrop gives politicians the incentive to invest in the proper level of loss control: More mitigation reduces the likelihood of having to make politically unpopular decisions like raising taxes, cutting other spending, or producing larger deficits after a terrorism loss. Can the Government Really Construct More Accurate Loss Distributions? This line of reasoning, though, raises several issues. First, the argument’s basic premise is suspect. To be sure, the U.S. government can more easily monitor al-Qaeda chatter” than the private sector -- although the chatter itself and the costs of associated with “code orange” security might be the newest form of terrorism. But it is unlikely that 42 the government holds closely the information that would allow it to systematically construct superior loss distributions relative to private firms that have money on the line. Even the U.S. Department of Defense evidentially doesn’t believe that it has a monopoly on information as well as the ability to process it better than the private sector. In July, 2003, the DoD’s Defense Advanced Research Project Agency announced an initiative, "The Policy Analysis Market," as an attempt to improve its human intelligence. This market would have allowed participants to bet on futures contracts over various political and civil outcomes including the assassination of Palestinian leader Yassar Arafat and a missile attack by North Korea. The DoD defended its plan, saying that a market system was highly accurate at predicting such outcomes. The plan was abandoned only after pressure from some members of Congress, including Senator Byron Dorgan (D-North Dakota) who referred to it as “unbelievably stupid” and Senator Ron Wyden (D-Oregon) who referred to it as “ridicules and grotesque.”31 Since the DoD market was not implemented, it is impossible to determine how well it would have actually worked. But the “Saddam Hussein futures market,” created by TradeSports Exchange, LTD., in Ireland earlier in the year gives some initial clue. As of February 10, 2003, it predicted there was only a 43% chance that Hussein would be disposed as the ruler of Iraq by March 31, 2003, but an 82% chance he would be gone by May 30, 2003.32 These accurate predictions were made by the market (after 42,000 trades) well before ground troops invaded Iraq in March, 2003, and obviously well before President Bush declared an end to major military operations in May, 2003.