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The Financial Risks of Terrorism: Who should pay for the
economic consequences of a terrorist attack in the United States?
In August 2005, the Wharton
Risk Management and
Decision Processes Center published
TRIA and Beyond, an
analysis of the Terrorism Risk
Insurance Act of 2002 (TRIA), which
will expire December 31, 2005, if not
renewed. The Risk Center's report offers
policymakers, key industry representatives,
and other interested parties
an analysis of what roles the public and
private sectors should play with respect
to terrorism risk coverage in the United
States. The report was produced by
a nine-person team, led by Howard
Kunreuther, co-director of the Center,
and Erwann Michel-Kerjan, a senior
research fellow at the Center. The
other authors include Neil Doherty,
Wharton professor of insurance and
risk management; Paul Kleindorfer,
Wharton professor of operations and
information management; Mark V.
Pauly, Wharton professor of health care
systems and business and public policy;
Scott Harrington, Wharton professor
of health care systems; Center research
associate Esther Goldsmith, and senior
fellows Irv Rosenthal and Peter
Schmeidler.
TRIA's primary goals, according to
language in the act itself, are to protect
consumers by maintaining "widespread
availability and affordability of property
and casualty insurance for terrorism
risk" and to allow a transitional period
during which private markets can
adjust to the new risk environment.
Before TRIA expires, the U.S. Congress
must decide what, if anything, should
replace it.
As the insurance industry, government
and modelers try to manage the
risks of terrorism, they face a number
of challenges—including continuing
terrorist attacks abroad (most recently,
the July 7 bombings in London), fear
of reprisals for the U.S. invasion of
Iraq, and an underlying insecurity that
may now be a permanent feature of the
national psyche.
A Post-9/11 World
"The TRIA and Beyond study is part
of the mission of the Wharton Risk
Center to understand individual and
organizational behavior with respect
to low probability, high consequence
events and then suggest strategies for
managing these risks," says Kunreuther.
Terrorism insurance was the main focus
of the Center's annual meeting in
February, which drew approximately
60 participants representing 25 organizations
from the federal government
and industry to academia and research
institutions.
The underpinning of the report, according
to Michel-Kerjan, rests on the
idea that if homeland security is indeed
seen as one of the top priorities of the
national agenda, "then how to provide
financial protection against terrorist attacks
should be on this national agenda
as well... Quite surprisingly, before
this Wharton study, no concerted effort
had been made in the U.S. since
the passage of TRIA to address that
question by bringing together interested
parties across a broad spectrum."
And yet, Michel-Kerjan adds, there
is evidence that the U.S. and its allies
"remain the prime target of several terrorist
groups which aim to inflict mass-casualties and economic disruption."
Insurers are now required by the
Terrorism Risk Insurance Act to offer
coverage against foreign, but not domestic,
terrorism. The federal government
has agreed to underwrite most
of the risk for the three-year life of the
Act as a substitute for the reinsurance
industry, which largely withdrew from
coverage after suffering about three-quarters of the $40 billion losses stemming
from the September 11 attacks.
The official position of the U.S.
Treasury—which released a report
on TRIA this June—and the
Congressional Budget Office (CBO)
has been that private markets should be
able to adjust to the new environment
and that TRIA was meant to provide
a "transitional period" in which those
changes were to take place—i.e., that
the insurance industry would by now
have found ways to offer coverage to its
clients and cover its own risks at reasonable
rates.
However, the TRIA and Beyond
report suggests that the necessary
changes and adjustments have not yet
been made and that there is a need
for some type of long-term private-public partnership for providing terrorism
insurance. Indeed, one of the
key recommendations of the Wharton
Risk Center report is a call for the establishment
by the U.S. Congress of a
national commission on terrorism risk
coverage, which should be given time
to comprehensively assess the issues involved
before permanent legislation is
enacted.
Kunreuther points to a number of
factors which currently prevent the private
market from working efficiently to
assess and to price this kind of risk, and
which make terrorism a particularly
vexing problem for markets. "A key
point is that terrorism is different from
low-probability events such as natural
disasters. It's not that you can precisely
estimate the risk of an earthquake or a
hurricane. But you do have scientific
data; you do have a lot of information;
there are quantitative models that have
been built."
Insurers, he adds, "are more comfortable
determining a premium for
coverage of these events. With terrorism,
it is extraordinarily difficult to
estimate the likelihood and location
of the next attack. Terrorists can take
action in reaction to what others have
done. If protective measures are in
place on some buildings or modes of
transportation, then other courses of
action will be planned. Witness the
recent London attacks in July on the
transit system. Probability does not
play a role in the determination of
premiums for terrorism coverage by
insurers."
Another key factor in the inability
of the market to manage the risk of terrorism
is the impact of state mandated
coverage. As the report notes: "The
mandatory coverage of terrorism losses
in workers' compensation policies in
all states and mandatory coverage in
approximately one-third of the states
of any losses from fires that occur following
a terrorist attack, whether or
not the firm has purchased terrorism
insurance, opens up insurers to the possibility
of large losses that could lead to
some insolvencies."
As Kunreuther notes: "You don't
really have a free market today. You
don't have the ability to say, 'I will
write this coverage or I won't write
this coverage.' Some coverage, you are
forced to write."
Domestic vs. Foreign
Terrorism
The current law contains quirks that
TRIA and Beyond suggests need to be
addressed. Paramount among them is
a distinction between "domestic" and
"foreign" terrorism. The former is currently
not covered under TRIA. What
do these distinctions mean in the current
environment, Kunreuther asks?
How would one categorize the recent
bombings in London, for example?
The first wave, on July 7, was carried
out by a group of British-born men,
whose parents were immigrants and
who may or may not have had foreign
support, though they were clearly motivated
by foreign events. If the bombings
had been carried out in New York
or Chicago or Houston, would TRIA
have applied? There is no clear answer
to this question.
If TRIA were renewed for a limited
period of time, the report's authors
recommend a comprehensive series
of strategies to be studied with an eye
toward creating long-term solutions
to the problem of terrorism insurance.
Some of these solutions can be implemented
by the private sector; others
will require either governmental action
or support. The options cited include:
-
Deploying the capital of potential
target firms. "We would envision,"
the authors write, "that a large part
of terrorism risk is, and will continue
to be, absorbed by the firm's
own capital, so that it is, in fact, self
insured. Moreover, in the case of
commercial property, institutions
providing long-term debt financing
to property developers could possibly
underwrite potential losses from
terrorism and charge higher interest
rates to reflect the additional risk. In
effect this would spread part of the
risk across all of their shareholders."
-
Reducing insurers' and reinsurers'
tax costs of holding capital, with the
caveat that such a program should
be designed to avoid "significant tax
deferrals unrelated to the program's
objectives of expanding the capacity
to insure losses from terrorism (and
possibly other extreme events)."
Deploying capital of reinsurers.
"One possibility would be a TRIA-like program without individual
insurer deductibles that would only
provide payments from the government
once losses exceeded a large
aggregate threshold. This approach
would stimulate the demand for
reinsurance and avoid some of the
distortions associated with individual
insurer deductibles and inclusion of
captives in the program," the report
states. "Another possibility would be
to base any federal reimbursement
of terrorism losses on net (i.e., after
reinsurance) losses without requiring
that reinsurers make available terrorism
coverage."
Facilitating the use of terrorism catastrophe
bonds. The report recommends
a study "to determine what
are the institutional and regulatory
obstacles to the development of a
more robust market for terrorist cat
bonds and what steps could be taken
to modify the current situation."
Mutual insurance pools, which the
authors note "have been developed
in several European countries before
and after 9/11 in combination with a
government backstop."
Publicly administered mutual insurance.
"The plan might be designed,"
the report suggests, "so that each
insurer would choose a level of protection
through the mutual pool and
pay an estimated premium. If either
no loss or minor losses occurred, any
excess premiums above a predefined
threshold would be returned to insurers
in proportion to their original
purchases. In the event of large losses
that exceed the plan's accumulated
resources, policyholders would be assessed
an additional amount to cover
claims according to the terms of the
arrangement."
Federal reinsurance with explicit premiums.
"An alternative to a TRIA-like arrangement, where there is no
upfront charge to insurers for the
federal backstop, would be a federal
reinsurance program with explicit
premium charges levied [in advance
of a disaster's occurrence] by the government."
"As the threat of terrorism is likely to
be with us for a long time to come,"
Michel-Kerjan notes, "there is a need to
undertake a concerted national effort.
The Wharton Risk Center team has
benefited from interactions with a large
number of decision-makers, both corporate
and public, in arriving at these
suggested strategies; we hope the final
report reflects this diversity."
Originally published by
Knowledge@Wharton August 10, 2005
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