Despite the first terrorist attack against the World Trade Center in 1993, terrorism was still included in most commercial insurance policies as an unnamed peril in 2001. The attacks of September 11, 2001 would soon inflict over $35 billion of insured damage, two-thirds of which was paid by reinsurers worldwide—at that time the most costly disaster in the history of insurance, now the second to Hurricane Katrina.
Most reinsurers stopped covering this risk. In the immediate aftermath of 9/11, insurers operating in the U.S. thus found themselves with significant amounts of terrorism exposure in their existing portfolio with limited possibilities of obtaining reinsurance to reduce the losses from a future attack. Most of them decided to stop covering terrorism as well.
The construction and real estate industries claimed that the unavailability of terrorism coverage delayed or prevented projects from going forward because of concerns by lenders or investors. Political pressure from these groups and others led Congress to pass the Terrorism Risk Insurance Act of 2002 (TRIA), a $100 billion risk-sharing arrangement between the insurance industry, all commercial policyholders and the federal government (U.S. Congress, 2002).1 On December 26th, President Bush signed into law the Terrorism Risk Insurance Program Reauthorization Act of 2007, extending the Act through 31 December 2014 in a form similar to TRIA. But is TRIA the best program for dealing with the risk of terrorism?
Principles for Guiding Catastrophe Risk-Sharing Arrangements
We propose the following five principles for evaluating insurance and other risk transfer programs for providing financial protection against catastrophic risks:
Risk-based Premiums: Insurance and other risk transfer programs’ premiums should reflect the risk. The premiums will then signal to individuals and firms the hazards or threats they face and encourage them to engage in cost-effective mitigation measures to reduce their vulnerability to catastrophes.
Sufficient Demand for Coverage: The demand by individuals and firms for insurance coverage with risk-based premiums should be sufficiently high so that insurers can cover the fixed costs of introducing a program for providing coverage and spreading the risk broadly through their portfolios.
Minimize Likelihood of Insolvency: Insurers and reinsurers should determine how much coverage to offer, and what premium to charge against the risk, so that the chances of insolvency are below some predefined acceptable threshold level.
Equitability: Insurance and other risk transfer programs should be fair to insurers, reinsurers, policyholders, and the general taxpayer where there is government participation.
Minimize Gaming: There should be no economic incentive for some insurers or policyholders to take advantage of provisions in the insurance or risk transfer program by undertaking strategic behaviour.
Terrorism Risk Sharing under TRIA
To evaluate how well these principles apply to TRIA, we examine market data for the period 2003-2006 and the impact of the new legislation on insurers’ behaviour.
Risk-based Premiums: There are limited data for estimating the likelihood of a terrorist attack and its resulting consequences, so it is difficult to know whether premiums are risk-based (Kunreuther and Michel-Kerjan, 2006).2 Still, the evolution of prices over time reveals the market’s assessment of that risk. TRIA’s most important success has been to significantly reduce and stabilize the price of terrorism insurance compared to premiums charged in the year that followed 9/11. Data provided by Marsh on over 1,600 client firms in the U.S. for 2004, 2004 and 2005 reveal that the cost of property terrorism insurance decreased significantly in 2005. The median terrorism price, which is calculated as the ratio of premium to total insured value, fell from $57 per million dollars of total insured value in 2004 to $42 in 2005, a decline in the average cost of terrorism coverage by over 25 percent (Marsh, 2006).3 These rates are actually much lower than those in European countries such as the U.K., France and Germany.4
Sufficient Demand for Coverage: The requirement under TRIA that insurers offer terrorism coverage, coupled with the relatively low premiums, has significantly contributed to an increase in the take-up rate. Data provided by Marsh show a significant and fairly continuous increase of the take-up rate, from 23 percent in the second quarter of 2003 to 62 percent in the fourth quarter of 2006. These data suggest that most of the surveyed companies that wanted such coverage have now purchased it.
Minimize Likelihood of Insolvency: Under TRIA, 80 percent the losses above insurers’ deductibles will initially be covered by the federal government and eventually be paid by all policyholders and taxpayers. That drastically limits the possibility of insolvency. For workers’ compensation coverage, only a few insurers will bear the brunt of the losses from a mass-casualty terrorist attack. For instance, in California, the State Compensation Insurance Fund represents half of the workers’ compensation market in the state. Since workers’ compensation providers are not able to exclude terrorism from their policies, in the absence of federal backstop some of these insurers would likely become insolvent after a large terrorist attack.
Equitability: Who should pay for the losses following a terrorist attack? TRIA holds that if the insurance industry suffers terrorism losses that require the government to cover a portion of their claims, then these outlays shall be fully or partially recouped ex post by levying a surcharge on all commercially insured policyholders, not just the policyholders who had purchased terrorism coverage. This implies that if losses are sufficiently high, the responsibility for recouping these payments rests with all firms who have purchased insurance in any of the TRIA-covered lines. In a recent study in which we consider various terrorist attack scenarios, we show that this change will shift a significant portion of the losses that could have been paid by taxpayers to all commercial policyholders (Kunreuther and Michel-Kerjan, 2006).5
Minimize Gaming: This principle has not been considered by those who have designed the TRIA program. Now that TRIA has been extended for seven years, if it is not reviewed on a regular basis, very large insurers with low deductible/surplus ratios could strategize by significantly increasing their terrorism underwriting. Any insurer with a low deductible/surplus (D/S) ratio would have an economic incentive to write a large number of policies in a concentrated area subject to a terrorist attack due to the positive correlation in these losses.
In other words, the insurer knows that if one of these buildings is damaged or destroyed, the surrounding ones are also likely to suffer severe damage. They would then collect large amounts of premiums for terrorism insurance but would be financially responsible for only a small portion of the claims –their deductible. Commercial policyholders (whether or not they are covered against terrorism) and the federal government would absorb the residual insured losses. This is inequitable, because the policyholders of those insurers who do not suffer any loss are responsible for the same amount of repayment to the government in the form of a surcharge as are policyholders in companies that suffered large losses and were subsidized by the government.
On the other hand, an insurer may not be willing to assume the large aggregate exposure implied by a gaming strategy because by doing so it would increase the likelihood that it will experience medium to large losses below its TRIA deductible. In addition when an insurer decides whether to write more terrorism coverage, it needs to consider its aggregate exposure from a much broader set of risks (e.g., fire, theft, work injury). Finally insurers may be also concerned that Congress will amend a long term/permanent TRIA-like program if legislators observe such strategizing.
Covering commercial enterprises against terrorism risk constitutes a new insurance market in the United States. Given that millions of companies are now covered, the market has become substantive in just a few years.
The series of natural and man-made disasters that occurred at an accelerated rate in the last few years demonstrate that we have entered a new era of large-scale risks and mega-catastrophes. Given the increased globalization of economic and social activities, future catastrophes will have both devastating impacts on victims who directly suffer and indirectly affect many others located hundreds if not thousands of miles away. This raises important questions, such as the implication of optimal risk sharing and price arrangements when the risk is highly uncertain, and the appropriate roles and responsibilities of the public and private sectors.
The United States has not suffered a terrorist attack for more than six years, which may breed complacency. Attacks in other countries and the eight years that separated the two attacks against the WTC in 1993 and 2001 tell us, however, that the risk of a large-scale attack against the U.S. is real and will be with us for a long time to come. Public policies can help insure against this risk.
1 The complete version of the 2002 and 2005 Acts can be downloaded at: http://www.treas.gov/offices/domestic-finance/financial-institution/terrorism-insurance/resources.shtml
2 Kunreuther, H. and E. Michel-Kerjan (2004), “Policy-Watch: Challenges for Terrorism Insurance in the United States,” Journal of Economic Perspectives, 18 (4), pp. 201-214.
3 Marsh (2006), Marketwatch: Terrorism Insurance 2006.
4 Michel-Kerjan, E. and B. Pedell (2006), “How Does the Corporate World Cope with Mega-Terrorism? Puzzling Evidence from Terrorism Insurance Markets,” Journal of Applied Corporate Finance, 18 (4), pp. 61-75, December.
5 Kunreuther, H. and E. Michel-Kerjan (2006), “Looking Beyond TRIA: A Clinical Examination of Potential Terrorism Loss Sharing,” Working Paper No. 12069 (Cambridge, Mass.: National Bureau of Economic Research).