The economics of kidnapping and ransom insurance

Anja Shortland (King's College London) recently wrote a piece for the Washington Post's Monkey Cage, on the economics of kidnapping and ransom insurance, based on her forthcoming article in the journal Governance (sorry I don't see an ungated version online). I was intrigued, so I read the journal article, and it has lots of bits of interest, such as:

The market for kidnap insurance is characterized by externalities: Cash-rich victim stakeholders can increase kidnappers’ ransom expectations and encourage new kidnappings. Insurers need to prevent quick payments of premium ransoms, but can only do so at a cost...

For the market to be stable and risks to be calculable, this externality needs to be managed. Given the impossibility of enforcing “proper” ransom negotiations through contracts due to high transaction costs, the Coasean prediction would be a single supplier of kidnap insurance...

The Lloyd’s solution is, therefore, an ingenious answer to the problems presented by kidnap insurance. All kidnap insurance is underwritten or reinsured at Lloyd’s...

Kidnap insurance at Lloyd’s is, therefore, a perfect example of the way in which externalities and transactions costs shape the institutions, which make up the economic system...

In ECON100 and ECON110, we talk about the private solutions to an externality problem, one of which is integration - the party creating the externality and the party suffering from the externality combine into a single entity (the classic example is a beekeeper and an orchard, who combine into a single firm - an example which I've written about before). Shortland argues that this is also the case for kidnapping and ransom insurance. If victims' families pay too much ransom, then they impose additional costs on future kidnap victims' families, because kidnappers will expect larger ransoms to be paid. Because all kidnap insurance is underwritten or reinsured at Lloyd’s, this is like integration (though not exactly, since this is integration into a single market space and not into a single firm). It allows easy sharing of information about kidnappings and ransoms paid, and ensures that all insurers follow the 'rules' that reduce any externality problems. Because Lloyd's has complete control over who can be part of this market, it is relatively easy to enforce standards of behaviour for the insurers.

It also explains why these insurers offer pro bono advice to the uninsured. By controlling negotiations between the uninsured victims' families (or employers) and kidnappers, the insurers (or rather, their agents) can reduce any spillover externalities. That is, they ensure that future ransoms will not escalate because of excessive ransom payments by uninsured victims' families or employers.

Now, we know insurance leads to moral hazard problems. Moral hazard arises when, after an agreement is made, one of the parties has an incentive to change their behaviour (usually to take advantage of the terms of the agreement) in a way that harms the other party. In the case of kidnapping and ransom insurance, once a person has insurance their incentives change slightly - they may engage in riskier behaviour safe in the knowledge that any future ransom will be paid by the insurer. So, we might expect to see people take fewer precautions to avoid being kidnapped. So, I found this bit from the article interesting:

The maximum cover is limited to the ransom the client (corporate or family) can raise themselves. The ransom is reimbursed after payment and the insurance contract cannot be used as collateral—meaning the victim stakeholders actually have to raise the ransom themselves initially. Employers are not allowed to discuss the insurance with their employees—doing so invalidates the insurance cover... All these stipulations serve to reduce moral hazard among the insured.

So, because the victim doesn't fully avoid the costs of being kidnapped (and probably does not even know they are insured!), the moral hazard problems are reduced.

Finally, back to externalities, Shortland identifies a real problem with governments negotiating directly with kidnappers on behalf of victims' families:

Governments that intervene on behalf of kidnapped citizens regularly pay premium ransoms... Unlike the participants in the private governance regime, governments often act myopically and under media pressure. They have neither binding budget constraints nor a profit motive to contain ransoms. There is no mechanism to internalize the spillovers of one government’s settlements on other negotiations. Paying multimillion dollar ransoms solves political problems in the short term but confers significant externalities on concurrent and future victims, their governments, and the insurance sector.

I'd suggest that there is a case for governments to also rely on the services of the insurers' agents, rather than handling these negotiations themselves. If they can do so anonymously (as the insurers do), then the outcome would be better, in terms of lower future ransoms and lower incentives for kidnappers.

[HT: Marginal Revolution]