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

Business Economics, April, 2002 by Howard Kunreuther

An EP curve depicts the probability that a certain level of loss will be exceeded on an annual basis. To illustrate with a specific example, suppose one was interested in constructing an EP curve for dollar losses to structures in Los Angeles from a future earthquake. Using probabilistic risk assessment (PRA), one combines the set of events that could produce a given dollar loss and then determines the resulting probabilities of exceeding losses of different magnitudes. Based on these estimates, one can construct the mean EP curve depicted in Figure 1. By its nature, the EP curve inherently incorporates uncertainty in the probability of an event occurring and the magnitude of losses. This uncertainty is reflected in the five percent and ninety-five percent confidence interval curves shown in Figure 1.

The EP curve is the key element for evaluating a set of risk management tools. Its accuracy depends upon the ability of the scientific and engineering community as well as social scientists to estimate the likelihood and impact of events of different magnitudes using quantifiable measures such as dollar damage, business interruption losses, number of fatalities, or people injured.

It is a lot easier to construct an EP curve for natural disasters and chemical or nuclear power plant accidents than it is for terrorist activities. But even for these more predictable events there is considerable uncertainty with respect to both their probability of occurrence and the resulting damage. In this regard, here are a few questions to ponder:

* What are the chances that Los Angeles will have an earthquake of magnitude 7.0 or greater next year, and what will be the physical damage and indirect losses?

* What is the likelihood of a severe nuclear power accident somewhere in the United States, and what would be the resulting impacts?

* What is the probability that an airplane will crash into the Sears Tower in the next year, and how serious would the consequences be?

* What are the chances that there will be a terrorist-induced smallpox epidemic in the United States in the next five years, and how many people would be affected?

Condition 2: Setting Premiums for Specific Risks

Once the risk has been identified, the insurer needs to determine how much coverage to offer and what premium to charge so as to make a reasonable profit while not subjecting itself to an unacceptably high chance of a catastrophic loss. There are a number of factors that influence these decisions. In the discussion that follows I assume that insurers are free to set the premiums at any level they wish. In reality, state regulations often limit insurers in their rate-setting process.

Ambiguity of Risk. Actuaries and underwriters charge a much higher premium for an ambiguous risk than for one where the probability is well specified and the outcomes are known. Empirical data support this point. Kunreuther, et al, (1995) conducted a survey of 896 underwriters in 190 randomly chosen insurance companies to determine what premiums would be required to insure a factory against property damage from a severe earthquake.