The role of insurance in managing extreme events: implications for terrorism coverage - Statistical Data Included

Business Economics, April, 2002 by Howard Kunreuther

The terrorist attacks on the World Trade Center and the Pentagon have created a heavy demand for insurance against such events. However, it is difficult to price insurance against extreme events because the probability of such events happening again is highly ambiguous, and the potential loss is highly uncertain. This paper explores the analytic issues that insurers must resolve in offering such insurance, including the calculation of premiums, the capital necessary to provide insurance, and options for raising such capital. It also explores the possibilities for public-private partnerships for providing such insurance if private insurers are unwilling or unable to do so, drawing on experiences of other countries. Finally, it identifies a number of issues that must be resolved before the private sector can provide insurance against terrorist attacks and other extreme events.

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A key question raised since September 11th is the appropriate role of the private and public sectors in reducing losses and offering insurance protection against extreme risks such as natural disasters, technological accidents, and terrorist activities. In recent Congressional testimony on terrorism insurance, Richard J. Hillman of the U.S. General Accounting Office (GAO) indicated that "both insurers and reinsurers have determined that terrorism is not an insurable risk at this time" (General Accounting Office, 2002).

The following scenario (with fictitious names) illustrates the challenges and opportunities facing private companies in this regard:

Over the past ten years, the AllRisk (AR) Insurance Company has provided $500 million in coverage to Big Business (BB) Inc. against risks to its building, including those due to terrorism. AR covers $100 million itself and has purchased an excess of loss reinsurance contract from Reinsurance Enterprise (RE) to cover the remaining $400 million. Given the events of September 11th, RE has decided that terrorism will no longer be included in its coverage because of the uncertainties associated with the risk. BB needs terrorism coverage since the bank that holds its mortgage requires this as a condition for the loan. AR must decide whether or not to continue providing BB with the same type of insurance as it has had previously and, if so, how much coverage it is willing to offer and at what price.

This scenario raises the following questions that this paper will address:

1. What factors determine whether the risk is insurable?

2. How much capital will AR require in order to provide protection against terrorism?

3. What role can and should the private and public sectors play in providing protection against terrorism?

The next section turns to Question 1 by showing that uncertainty and ambiguity regarding the risks is likely to raise the premiums considerably, particularly if the insurer is concerned with the potentially large losses, as is the case with the terrorism risk. The paper then addresses Question 2 by showing why terrorism coverage is likely to be uninsurable if investors require large returns for providing funds to cover this risk. I then turn to Question 3 and contend that today there is a role for the federal government to play in conjunction with the private sector because of the large uncertainties associated with the terrorism risk. The paper concludes with a set of open questions for future research.

Insurability of Risks

What does it mean to say that a particular risk is insurable? This question must be addressed from the vantage point of the potential supplier of insurance who offers coverage against a specific risk at a stated premium. The policyholder is protected against a pre-specified set of losses defined in the contract.

Two conditions must be met before insurance providers are willing to offer coverage against an uncertain event. Condition 1 is the ability to identify and quantify, or estimate, the chances of the event occurring and the extent of losses likely to be incurred. Condition 2 is the ability to set premiums for each potential customer or class of customers. This requires some knowledge of the customer's risk in relation to other potential policyholders. If Conditions 1 and 2 are both satisfied, a risk is considered to be insurable. But it still may not be profitable. In other words, it may be impossible to specify a rate for which there is sufficient demand and incoming revenue to cover the development, marketing, operating, and claims processing costs of the insurance as well as yield a net positive profit over a prespecified time horizon (e.g. five years). In such cases the insurer will opt not to offer coverage against this risk.

Condition 1: Identifying the Risk

To satisfy this condition, estimates must be made of the frequency of specific events and the extent of losses likely to be incurred. Such estimates can use historical data and/or scientific analyses. One way to reflect what experts know and do not know about a particular risk is to construct a loss exceedance probability (EP) curve.