Odd Lots - Why Negotiating a Ransom Is the Trickiest Trade in the World

Episode Date: February 3, 2017

There are all sorts of reasons why markets break down. A lack of trust. Incomplete information. Divergent incentives. A lack of experienced actors. So it's hard to imagine a trickier market than kidnapping. Emotions are running rampant. You know very little about your counterparty. And there's no guarantee that anyone will stick to an agreement. On this week's Odd Lots, we speak with Anja Shortland, who is the research group leader for Political Economy of Peace and Security at King's College in London, about the economics of ransom payments, which she terms "the trickiest trade in the world." We talk about the role of kidnapping insurance and professional negotiators -- and the huge mistake that most cinematic depictions of kidnapping make.See omnystudio.com/listener for privacy information.

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That's vanguard.com slash audio. All investing is subject to risk vanguard marketing corporation distributor. Hi, and welcome to another edition of the Oddlots podcast. I'm Tracy Allaway. And I'm Joe Wisenthal. So, Joe, this is the third and final episode in our first ever series about the intersection of crime, finance, and markets. Are you sad or excited for the finale? I'm really excited about this one. I mean, I really, you know, I think a general theme of all of our has been the markets that where markets appear that people don't talk about very much, but these crime ones have been really in the sweet spot. And I think today's is going to be a really good one. All right. So one of the reasons that you and I find these sort of crime

markets so interesting is that they often deal with really entrenched problems in economics. They're honestly some of the most difficult markets in the world. And I think the one that we are to talk about today is probably the most problematic in all of existence, like every single big economic problem you can think of, stuff like moral hazard, adverse selection, information asymmetry, all of that is present in this market. And if you get it wrong, someone might die. So there's an added bit of drama here. Right. The consequences of this market that we're going to talk about are enormous, because as you mentioned, if the market doesn't work right, it could result in death. And on top of all the things that you mentioned, adverse selection,

moral hazard, information, asymmetry, there's also deep issues of emotion and morality. And, you know, economists sometimes like to abstract those things away and sort of assume that they don't exist. But we're going to be talking about a market where it's essentially impossible to, wipe those things away, which has the benefit of sort of informing our understanding of all markets by forcing us to confront those things. Yeah, that's exactly right. And one of the more amazing things about this particular market is that there's actually a pretty decent solution to these problems. A corporate entity has actually come up with a good way of dealing with these problems, and it seems to be working out reasonably well. I guess we should, we should go ahead and say what it is.

I know. Stop tiptoeing. Why don't you say what it is and introduce our guest. All right. We are going to be talking about the kidnapping market, how insurers actually insure kidnapping risk, how the whole process of ransom actually unfolds. So here with us today to discuss the kidnapping market is a woman called Anya Shortland. She has written a fantastic paper on this very subject called Governing Kidnap for Ransom Lloyd's as a Private Regime. She is also a reader in political economy at King's College, London. So without further ado, Anya, thank you so much for joining us. Well, thank you for bringing me on to the program. So did Joe and I get that introduction right? Is it fair to say that kidnapping or the kidnapping market is probably one of the most difficult markets around?

Well, I certainly think of it as the trickiest trade in the world. So each individual trade is absolutely fraught with difficulty. I think this is a, we have the title to this episode, the trickiest trade in the world. Thank you very much for that. That solves that problem. Why is it? Why do you consider this the trickiest trade in the world? Well, it has, it starts off with a random pairing of transaction partners.

You don't get any choice about who you're going to be trading with. Usually a kidnap is a black box event. Somebody hijacks a car or a boat and outjump some hostages. So you don't know anything about the people that you're going to be transacting with. And then you have to do a one-off transaction with them. The problem with that transaction and the incomplete information is that nobody knows what kind of price should be paid. So the people who have kidnapped a person don't know how rich or poor that person is. They might have a guess.

However, for the hostage stakeholders, the question is not necessarily how much can I raise, but how much will the kidnapper settle for. So you have that bargaining problem with incomplete information. Unfortunately, information can be extracted through the strategic use of violence. You can't stop the kidnappers from chopping off digits or at least threatening to do so. You might use extreme violence if you think you've got a hostage that isn't worth very much and therefore raise the price of other hostages. Eventually, perhaps you agree a price and then you have to actually conduct the trade.

So getting to a price is difficult. Then you have sequential exchange. Somebody's got to pay, and then the hostage has to come back. And any sequential trade is problematic. This one is particularly problematic because it's clandestine, and it can be intercepted. So you don't actually know whether you've managed to pay, because if you put some money somewhere in a bin, according to the kidnappers' instructions. Somebody else could empty that bin before the kidnappers get to it.

So you can't actually prove that you've paid. And then once you have paid and they have acknowledged that you have paid, then they still have to decide whether they want to release a future potential witness. And when you look at it like that, you think, well, this can't possibly go well. And then the amazing statistic is that if you're not, you're going to be able, you think, well, this can't possibly go well. if you're insured for this kind of thing, then it will go right 98% of the time. That was a remarkable summary of the problem. And I just found listening to that riveting.

And we're going to talk about this phenomenon where private companies provide insurance for executives and other people who are prone to kidnapping. But before we dive into the structure of the market, something that I'm particularly fascinated by, and this came up on a previous episode, is how do you collect data on this? I mean, this is sort of one of the fascinating aspects of criminal markets. It's not exactly, you know, listed in the newspaper or on the Bloomberg terminal, what the going rate is for a kidnapping victim. Ooh, that'd be a good index, Joe. That would be a great index. That would be a great chart of the day to do some time if we had that. But how does the process of data collection work?

in a market where nobody has any incentive to tell you anything? Well, that's exactly the difficulty of my research. In the end, it's about people trusting you to not divulge the information that you get, but that information is being collected. And there are people who share it within a community because one of the really important things, if you want to govern that market and make that market, and make that market stable is that you don't pay over the odds.

So you need to have information about how much a kidnapper gang is actually expecting. Yes, they will ask you for $10 million. But what you need to know is whether they actually settle for $7,000 or $12,000 or $100,000. The initial opening gambit gives you very little guidance as to what they'll actually settle for. So yes, people collect that information and they share it within the community of experts to make sure that the hostage stakeholders pitch their opening gambit in expectations of settling, in the expectation of settling at a reasonable price for that region. for that particular kidnap group.

Anya, let's get back to that amazing success rate that you mentioned. I think it was 98% if you're insured for kidnapping. How exactly is that success achieved by private corporations, given all the really, really deep dramatic problems that you described previously? Well, to an economist, any trade becomes government. if there is a shadow of the future. Yeah, the key problem that I had straight away was this, it's a one-off transaction. If you have a shadow of the future, if the kidnapper knows that they're going to do this again and again and again.

And that whatever they do will feed into a community that knows what they've done in the past, then you have the potential for reputation building. So this will only ever work if people can build reputations. You talk about the corporation that's behind this and the specialists that behind it. The problem with reputation building and criminal markets are twofold. The victims don't talk, because the last thing you want to do is when you've just been through a kidnap is go to the newspaper.

I said, oh, I just paid half a million for my husband. that's going to be, that's going to attract attention on the wrong kind of criminal attention in the future. So people don't want to talk about it. They might talk about it within a small community and that's how local kidnap markets work. But similarly, a kidnapper would have to feel very self-assured to try and build a reputation. So you need to have a very discreet process. of exchanging information to replace the rate my kidnapper app.

Right. That we usually use nowadays to try and pool information about whether a trade partner is actually reliable. But if you have somebody who regularly blows their victim's brains out, takes a ransom and then doesn't even return the body, then you want to send the police in and not the guy of a, the ransom. So if a would-be kidnapper had the reputation of always blowing the victim's brains out, no matter what, it's pretty clear that people would not be willing to negotiate with them much,

that they wouldn't be very successful long-term in the trade. But do people actually get to know individual kidnappers? Do they know the identity of the counterparty? Or do they just get to know the general patterns of kidnappers, say, in a given area. Do the individuals have the reputation, or does the community of kidnappers get the reputation? I think it's a bit of both. Occasionally, you have kidnapping gangs. And sometimes you have this advertising thing, like the Mexican flower gang, that always sent the chauffeur's body back with a flower.

So, yes. So it does happen. But generally, you kind of know who's active in the area and you know the expectations. Because once you get one ransom paid in an area that will feed through the criminal community and then other people think, oh, I can do that. So their trade then will be conditioned on the previous ransom. Now, does the community enforce norms? So you talk about the idea of a kidnapping community.

If there is a bad actor, do other kidnappers discourage that? I think quite possibly you'd have a local mafia that would say, well, we don't want this kind of kidnapping here. Yeah, so I do think there's discipline. There's a lot of research on who governs the criminal side of the market. And the answer is usually there is a don, there is a mafia, and the mafia decides whether or not kidnapping happens. and if it does happen, what kind of things are acceptable? Because if you're maximizing return over a long period, then again, you don't want that kind of kidnapper on your turf.

So they might well get rid of the more random elements. I'm sure it's only a matter of time until some really enterprising criminal comes up with a central clearinghouse for kidnappers to eliminate all counterparty risk. But on a more serious note, there is a sort of thematic tension that emerges from your work, which is that these kidnapping insurers, if they're too successful, then they basically risk encouraging a lot more kidnappings and having to pay out a lot more money. So how do they actually navigate that tension?

Yeah, so when Kidnapped Forensum Insurance was first developed as a product, the families negotiated, the families raised the ransoms, the families delivered the ransoms, and then the insurers reimbursed them afterwards. The problem was that was that the families weren't particularly careful about how much ransom they paid. They didn't resist the kidnappers' demands as much as would have been desirable, and ransom started to explode in the 1970s in Latin America, Ransoms went from half a million to a million to two million to six million to ten million to 30 million to 60 million.

And it would have become uninsurable if insurers hadn't done something about taking control of the ransom negotiations. So what they did was to bring in specialists to advise the families to make sure that they started to consider how much that... kidnapper would settle for rather than the maximum amount of money that they might like to afford to bring a treasured uncle back. Now, here's a question. Who's interest to the specialists, who do they work for? They work for the insurance company, right? They work for the insurance company. They advise the family and their job is to bring the hostage back safely for the minimum that the

kidnappers will settle for. So basically they work for both sides because the family is interested in the safe return and they work for the insurers because the insurers are interested in a stable market. They don't want premium ransoms to be paid. Because in theory, this could be yet another information asymmetry where there are again two parties, the stakeholders, the family of the kidnapping victim and the insurance company and the, and, you know, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, the, if somebody asks, if there are a million and you say, yeah, that's fine. The kidnappers will go back and say, well, if, If a million is fine, you're just happy to give it to me like that, then I would like five million. So you don't actually gain very much by giving in fast.

So as far as the kidnapper is concerned, they're trying to extract the maximum that you've got. And if they name a figure beyond their dreams of Averis and you say, yeah, that's fine. that's not going to work because there is nothing contractual that obliges the kidnappers to stick with a figure that they originally had in mind. It is all anarchic bargaining. Sometimes the kidnappers

will give somebody back if the family exceeds very quickly and then two weeks later another family member will be gone. So basically See, it is not really something where you can take shortcuts.

And the fact that you've got a highly experienced negotiator at your side, who can explain the process to you, who can reassure you, and who you know has already brought dozens of people back. And it will take five days and $10,000 rather than three hours under a million. if you know, if you have that background that they know what they're doing, then you probably ought to listen. So we've been talking about these insurance companies able to instill some discipline in the bargaining, ransoming process and create this very, very healthy success rate.

But there's a part of this that we haven't actually talked about yet, which is that in all of the kidnappings we've been discussing, we're talking about criminal gangs, mafia groups, doing kidnappings for profit. These insurance companies like Lloyds are actually prohibited from negotiating or ensuring if someone gets kidnapped from a terrorist group. Is that right? That is right.

Yes, it's illegal to facilitate or make or reimburse payments. where you have any reasonable cause to suspect and might go to a terrorist group. So, yes, the insurers are out as soon as somebody labels a group terrorist. So who makes that decision and why is that rule in place? This is about governments wanting to be tough on terrorist funding. And governments decide which groups they consider to be terrorists. And there is some leeway on this. So, for example, with the Somali pirates, there was a lot of suspicion that al-Shabaab might be getting some of a pirate proceeds.

And yet, the criminal label was applied because basically, once you start labeling something as a terrorist problem, then that beautiful, ingenious market structure that governs criminal kidnaps is sidelined, and things start to go. badly wrong. In your view, is this an error of policy? There are all sorts of problems when you put a government on the end of a phone line. The insurer will put the family or whatever stakeholder groups is most credibly cash constrained on the end of the phone. So if I was kidnapped, they put my husband on the phone, and however much my husband loves me, there's no way he could raise half a million. If you put Angela Merkel on the phone, there is no way that she can credibly signal to the kidnapper that the German state does not have $5 million to bring me back. That is a big difference.

So what is the budget constraint? What budget constraint can you actually demonstrate to the kidnapper? Secondly, why my husband would very much like me back, there is not pressure to do so immediately, whereas governments are generally quite keen to conclude and get this thing off their plate, especially if you have kidnappers who create media pressure for the return of our boys or our girls or whatever it is. And thirdly, insurers have devised a system to make sure that. the spillovers from premium ransoms are internalized within the community of insurers, whereas the German government doesn't really care and can't be punished for creating a premium

ransom precedent that then becomes problematic for the French government or the Italian government or the Spanish government five months down the line. So all the things that contain ransoms within the private sphere are missing in the government sphere. So when it comes to terrorist kidnappings, there is one trend that has been happening that I really wanted to ask you about. And that's, you know, we've seen people unable to get their governments to pay for their loved ones for the reasons that you just laid out. And then they don't have insurance for their loved ones because the insurers aren't allowed to pay out ransoms for terrorist kidnappings. But some of these families have been going online and doing

crowdfunding, right? Basically asking people for money to pay for ransoms. How does that affect the insurance market? Because I imagine that that could create some distortions in incentives. Certainly it would knock that discipline that we've been talking about. I haven't seen much about the crowdfunding, but what I have seen, of course, is the ransoms that certain European countries have quite regularly paid to terrorists. And that really creates a problem for insurers, because you talked about clearing houses earlier on. Are there clearing houses? Well, there certainly is a secondary market for hostages. So if you have a criminal market that settles at $30,000 or $50,000 and a terrorist market that settles somewhere between $5 million,

then it becomes very likely that the criminal kidnappers pass their hostages on to the terrorist organizations. We have to wrap up soon, but I want to ask you, you know, kidnapping is a pretty common theme in movies. There was a movie called Ransom, I think, or with Harrison Ford. What is the biggest gap between how most people view the negotiating process with hostage takers or with kidnappers and how it exists in real life? What's the ultimate way that this process by which a number is agreed upon and the delivery of the money happens? How do people get it wrong because most of their experiences through fiction?

I think the big difference is that once that negotiator arrives to advise the family, he will have a very good idea of how long it will take and how much it will settle for. So, yes, it will be emotionally, highly fraught, but in the background, you know that this is very likely to be done and less than a week and at a price that's not actually going to break the bank. and 98% of people come home. Yes, hostages die, but most of them die in escape attempts or because they had pre-existing medical conditions or because somebody tries to liberate them.

Those are the three real big dangers for hostages. That's good to know. Well, I don't know. That's just sort of good advice in case that we ever find ourselves in that position. But that's exactly the advice. that you would be getting if you were trained for operations in complex and hostile territories. And that's what everyone advises you. Hang in there. Don't be an alpha male. We'll get you out. Eddie Lampert, the hedge fund manager, did negotiate his own or did sneak out. Have you studied his case?

No, I haven't. The hedge fund manager who currently controlled Sears was kidnapped in 2003 and managed to trick his kidnappers into thinking the police were hot. on their tail through negotiation of he did it himself and then was able to sneak out. I have one tiny last little question. I'm sorry, very minor. Are there any escrow services for money drops? Well, yes, there is trying to make that payment process smooth is another big business and trying to find ways of actually proving that you have paid.

So I think one of the really nice illustrations of that where the ransom drops for Somali pirates where they're basically flying over with aircraft, the pirates lined up the entire crew to show that everyone was still alive. And then on the second flypath, the money was dropped. Photos were taken. So it was very clear that the pirates had been paid. And yeah, I mean, all of these releases went absolutely smoothly. Anya Shortland, that was a fascinating conversation. Thank you so much for joining us. Thank you. My pleasure. So now we know what to do if we're kidnapped, right? Don't be an alpha male. That's the number one piece of advice. I'm going to have to really resist my tendency to always try to be the alpha male in every situation, but I'm going to remember that.

I love that conversation. And I could have probably asked 100 more questions. That's why I asked that question at the end about whether they're escrow services to prove payment. But I think the fact that there are a million more questions we could have asked really speaks to exactly what you said at the the very beginning, that this is probably the most complicated transaction you can imagine in every little bit from proving the payment to figuring out who the hostage expert negotiator really works for. Every single aspect just seems so tricky and hard to manage. Yeah, I think I'm going to develop maybe a bit of a specialty in kidnapping academic research, because I really find this fascinating. And I'm surprised that more economists don't look at this as a sort of micro-corporated. of all the big issues that we so often find in behavioral finance and beyond. But it's definitely

one that I think can be further explored. I think that last point, too, about how in movies, kidnapping always seems like, you know, the negotiation doesn't seem to have any process. Yeah. It seems completely chaotic. It usually always falls apart at the end. Someone backtracks at the last second and then and the idea that in real life that it's a very emotionally fraught process but that it also is predictable usually ends in about a week that from the beginning the expert has a good sense of how much it'll cost it probably won't destroy the family's finances is so fascinating that this incredibly complicated transaction through markets and through expertise can actually be made kind of predictable from the very start should someone write

the movie about the insurance specialist, parachuting in, having really disciplined negotiations, talking about escrow services, making estimates of the ransom. I'm imagining, I'm imagining Steve Carell and him sort of coming in with a slightly ill-fitting suit and him, you know, something along that and him trying to be like this very nerdy insurance approach and everyone else freaking out and him calming everyone's nerves. I think it has to be a comedy. I would totally watch that. Me too.

All right. That is it for this episode of Odd Lots and for our series on markets and crime. I'm Tracy Allaway. You can find me on Twitter at Tracy Alloway. And I'm Joe Wisenthal. You can follow me on Twitter at the Star Wars. I'm June Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world.

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