A member of the Libyan security forces displays part of a document in Arabic describing weaponry. (Mohamed Ben Khalifa/AP)

Economists and social scientists often think about difficult economic transactions. Surely, one of the trickiest possible transactions is when ransom-payers try to bargain with kidnappers to get a hostage back. In an article recently published in Governance, I look at how the business of kidnapping works. Here is why kidnapping involves some tricky business relations, how private sector institutions work to resolve them and why governments have a harder time preventing kidnapping from escalating.

Kidnapping is hard

There are three important factors that make transactions between kidnappers and ransomers difficult — problems of trust, problems of bargaining and problems of execution.

First comes trust. The kidnappers and the ransom payers have every reason to mistrust each other. They are making a one-off deal, which means that there is a higher risk of cheating. Few victims are experienced in dealing with the criminal underworld. Even so, kidnapping for ransom is an established business model in many areas of the world.

Even apart from issues of trust, bargaining over the ransom is hard. The parties have to find a mutually agreeable price with very limited information. Potential ransom payers would ideally want to find out the minimum the kidnapper will settle for. But the kidnappers will threaten violence to probe the maximum stakeholders’ can pay.

Finally, executing the transaction — swapping the ransom for the hostage — is likely to be very complicated. The payment process is problematic: Ransoms can be intercepted by the police keen to make an arrest, opportunistic thieves or rival gangs. Furthermore, if kidnappers decide not to release the hostage, there is no way of forcing them to — so why release a potential future witness?

Nonetheless, the business model can work

Despite these huge trust and enforcement problems, kidnapping for ransom is endemic in many countries. A large number of multinational companies and NGOs operate in kidnapping hotspots such as Nigeria, Mexico, Iraq, Mali and Colombia. Employers have a duty of care: If they operate in these environments, it means they trust that abductions will be peacefully resolved. Perhaps even more surprisingly, the volume and cost of resolving kidnappings is sufficiently predictable for insurers to sell kidnapping for ransom cover.

My governance paper examines how this unusual market works. It focuses on a group of special-risk insurers at Lloyd’s of London, which cooperates to bring order to the trade in hostages and make it insurable.

How is the market for hostages organized?

The first principle that insurers adopt is that safe retrieval of hostages is paramount. The second guiding principle is that kidnapping cannot become too wildly profitable, for fear of further destabilization. In the language of economists, there must be no “supernormal profits.” If victims’ representatives quickly offer large ransoms, this information spreads like wildfire and triggers kidnapping booms. A good example is Somalia, where a few premium ransoms led to an explosion of piracy that could only be stopped by a costly military intervention.

Insurers have therefore created institutions to make sure that ransom offers meet kidnapper expectations and produce safe releases but that do not upset local criminal markets. Insured parties obtain immediate, free access to highly experienced crisis-response consultants in the event of a kidnapping. These consultants find out whether the person demanding the ransom actually holds a live hostage to bargain over, they advise on the appropriate negotiation strategy, and they reassure families when they inevitably receive dire threats of violence.

Because insurers can communicate outcomes confidentially, they can stabilize ransoms — as well as discipline rogue kidnappers. One kidnapper summarized this perception in the criminal community as “No one negotiates with a kidnapper who has a reputation for blowing his victims’ brains out.” Crisis responders also manage the ransom drop, removing a further obstacle to a successful conclusion. About 98 percent of insured criminal kidnapping victims are safely retrieved.

Negotiators face their own market problems

Of course, this “protocol” for ransom negotiations is costly. Tough bargaining takes time, imposing huge psychological costs on negotiators and on the victim’s family and tying up productive resources in firms. Experienced consultants are paid a substantial daily fee. It is very tempting to conclude negotiations early. Most of the cost of quick ransoms that are bigger than they ought to be is borne by future victims and their insurers, not the current victim’s stakeholders. An effective governance regime for kidnapping resolution therefore requires rules to prevent anyone’s taking shortcuts.

It would be impossible to prove beyond reasonable doubt that an insurer’s crisis responder deliberately cuts corners because ransoms are naturally variable. This makes it impossible for insurers to formally contract with each other and punish those who “overpay” kidnappers.

Here is how they resolve them

Insurers resolve this through an ingenious market structure. All kidnapping insurance is either written or reinsured at Lloyd’s of London. Within the Lloyd’s market, there are about 20 firms (or “syndicates”) competing for business. They all conduct resolutions according to clear rules. The Lloyd’s Corp. can exclude any syndicate that deviates from the established protocol and imposes costs on others. Outsiders do not have the necessary information to price kidnapping insurance correctly: Victims are very tight-lipped about their experiences to avoid attracting further criminal attention.

The private governance regime for resolving criminal kidnappings generally delivers low and stable ransoms and predictable numbers of kidnappings. Most kidnappings can be resolved for thousands or tens of thousands of dollars. This makes profitable kidnapping insurance possible. When the protocol fails, insurers sustain losses and must innovate to regain control.

Governments don’t have the same market structures

The outcomes of privately governed “criminal” kidnappings (where private firms or individuals pay the ransoms) contrast starkly with those of “terrorist” kidnappings (where governments are asked to pay ransoms or to make concessions). Here, insurers are prevented by law from ordering the market, leaving governments in the firing line.

Governments struggle to contain ransoms, and they often end up making concessions to terrorists despite their public “no negotiation” commitments. Government negotiators have no obvious budget constraints. They often prioritize quick settlements over containing ransoms. Finally, there is no international regime for preventing spillovers to subsequent negotiations. Citizens of nations who refuse to negotiate with terrorists are often tortured or killed to raise the pressure in parallel negotiations. Multimillion dollar ransoms in terrorist cases are therefore not really surprising — and such settlements reliably trigger new kidnappings.

So the current regime for resolving “terrorist” kidnappings has unintended consequences for current and potential future hostages, governments and terrorist financing. It might be that governments could learn some useful lessons from examining the ingenious and intricate private governance regime.

Anja Shortland is a reader in political economy at King’s College London.