Friday, February 24, 2017

The Economics of Kidnap Insurance

There is reason to be dubious, at least in theory, about  how kidnap insurance can work. After all, buying kidnap insurance only makes sense if you believe that, in the case of being kidnapped, it will increase your chance of being released. After all, if kidnappers know (or can figure out) that certain people have kidnap insurance, won't they tend to target such people? Also, if a kidnap victim has insurance  has insurance, won't the kidnappers demand the monetary equivalent of the earth, moon, and stars as a ransom? In these ways, might the presence of kidnap insurance increase the amount of kidnapping? On the other side, insurance companies have a profit motive to take actions that would reduce the number of kidnappings and the size of ransom payments. But if kidnappers make extraordinarily high demands and the insurance company pushes back, then it seems likely that negotiations over ransom will tend to break down--in which case the rationale for buying kidnap insurance in the first place would disappear. And how can kidnap insurance companies figure out a way to deal with the situation of kidnap victims who don't have insurance: if the representatives of those victims (who may in some cases be national governments) pay high ransoms, then it will be harder for the companies that sell kidnap insurance to keep other ransom demands down.

 Anja Shortland explores "Governing kidnap for ransom: Lloyd's as a `private regime," in an article forthcoming in Governance magazine (the publisher, Wiley, has laudably made an "Early View" preprint version of the article available here). The short answer to the concerns over how kidnap insurance markets are likely to break down is that if all the companies providing that interact with each other, swap information, and follow common protocols, then kidnap insurance can function. For kidnap insurance, Lloyd's serves as a place where that interaction happens. Shortland writes (citations omitted):

Kidnapping is a major (if largely hidden) criminal market, with an estimated total turnover of up to US$1.5 billion a year. Transnational kidnaps, where the victims are foreign tourists, high-net-worth local residents insured by multinational insurers, and the employees of foreign enterprises, are scary one-off events for almost all families and most firms. Ransoming hostages is beset with trust and enforcement problems. Kidnappers seek to maximize ransoms and can employ extreme violence to pressurize stakeholders to reveal their assets. Law enforcement may prepare rescue operations while families (pretend to) negotiate a ransom. Any sequential payment process is potentially problematic, but ransom drops can fail even if both parties act in good faith. Kidnappers need not release (live) hostages after payment and may demand multiple ransoms. Yet, despite these considerable difficulties—and contrary to general perceptions based on newspaper headlines—the vast majority of transnational kidnap victims survive and most cases conclude relatively quickly.  ...
Commercially, kidnap insurance is only viable under three (related) conditions. First, kidnaps should be nonviolent and detentions short—otherwise, individuals and firms withdraw from high-risk areas. Second, insurance premia must be affordable. Although insurance is only demanded if people are concerned about kidnapping, actual kidnaps must be rare, and ransoms affordable. Insurers struggle in kidnapping hotspots: High premia deter potential customers. ... Third, ransoms and kidnap volumes must be predictable and premium income must cover (expected) losses. If kidnapping generates supernormal profits, more criminals enter the kidnap business. Premium ransoms quickly generate kidnapping booms. Insurers, therefore, have a common interest in ordering transactions and preventing ransom inflation. ...
[K]idnap insurance is indeed controlled by a single enterprise: Lloyd's of London. Yet within Lloyd's there are around 20 international syndicates underwriting kidnap for ransom insurance. The syndicates compete for business according to clear protocols regarding how insurance contracts are structured, how information is (discreetly) exchanged, and how ransom negotiations are conducted. ...
All kidnap insurance is underwritten or reinsured at Lloyd's. By setting clear parameters for commercial resolution, Lloyd's enables “fair” competition between different providers and avoids kidnap insurance being sold monopolistically. There is a protocol for insuring and resolving kidnaps, which emerged from the members themselves. Its use is mandatory and it (largely) prevents individual insurers from conferring externalities to the rest of the sector. The insurance market works smoothly because Lloyd's enables relevant case information to flow easily between insurers without compromising client confidentiality. Underwriters constantly interact with each other and individuals who do not pass (truthful) information to the Lloyd's insurance community or spread it beyond its confines can be ostracized.
 Shortland has compiled an array of evidence on kidnaps and ransoms from nations in Africa, Latin America, the Middle East, and elsewhere. But she also includes some specific anecdotes that tell the story of how these dynamics often work out:
The owner-manager of a Mexican company is abducted at gunpoint. A ransom of US$1 million is demanded with a threat of mutilating the hostage. His kidnap for ransom insurance is activated. A crisis response consultant coordinates a crisis management team with the hostage's brother as the only point of contact with the kidnappers. The consultant advises that previous cases in this area have settled for around US$100,000 and that “we have yet to actually receive an ear….” The brother makes an initial cash offer of US$40,000 citing liquidity problems at the firm. This is progressively raised, but in decreasing increments. After 16 days the wife tearfully pawns her engagement and wedding rings to bring the total offer to US$99,814. The kidnappers accept, the crisis responder manages the ransom drop, and the hostage is safely released.
An aid worker is kidnapped in Yemen. Unbeknownst to the family, the NGO's strategic risk management plan includes kidnap for ransom insurance. Within 24 hr, a crisis response specialist convenes a crisis management team of senior staff to conduct the negotiation with the kidnappers. He personally assures the family that “… everything will be done to ensure the timely and safe return of the hostage.” The NGO is advised to negotiate, but to stall and reject the ransom demand of US$500,000. A former SAS officer bases himself in war-torn Aden to open indirect negotiations with tribal elders. After 36 days, the local sheik indicates that the hostage could be released in exchange for a new generator for his village. The NGO agrees, the unharmed hostage is released, and the NGO operates undisturbed afterward.
If you  are teaching about insurance markets and need to spruce up your classroom with a fresh and vivid example of adverse selection, moral hazard, and potential spillovers, this topic and very readable article could be a useful resource.