The Economics of Terrorism Insurance

The Economics of Terrorism Insurance Neil Doherty The Future of Terror Risk Insurance University of Southern California June 2005

Performance of Terrorism InsuranceversusPerformance of Terrorism Risk Management • Policy question has been framed as one on terrorism insurance • Insurance is only one of number of strategies for managing terrorism risk • “failure” of insurance market does not imply risk not being managed is inefficiently managed • Other risk management tools include • Leverage • Contingent financing • Structured debt • etc

Terrorism insurance issues • Is terrorism an “insurable” risk? • Is terrorism insurance market shaped by pre-existing imperfections? • Does market clear? • Would insurers be able to pay for mega loss? • Would post-loss supply be constrained by capital shortage?

Is terrorism an “insurable” risk? • Measurement of risk • Some progress in modeling severity - but • Difficulty of estimating frequency risk • Difficulty of game theoretic modeling • Federal government has access to sensitive risk information • Moral hazard • Hazard function of government policy • Foreign policy- counter-terrorism – homeland security • Does this suggest role of Federal govt. as risk bearer • Interdependent security • Can shift risk to others • Incentive to under-invest – benefits of security externalized

Is terrorism insurance market shaped by pre-existing imperfections? • Existing insurance market faces: • Compulsory insurance – • workers comp • Fire following some states • Rate regulation • Double taxation • Samaritan’s dilemma – expectation of ex post relief • Two broad choices for policy debate • Reduce existing market imperfections • Bolster insurance market to overcome imperfections

Does market clear? • Before TRIA little coverage • Coverage with TRIA • 54% AON sample buy some terrorism ins (TRIA/non certified/stand alone) • Varies across industry • HIGH -Real estate /transportation/health care • LOW – Pharma/chemicals/construction • Varies across region • HIGH – south-west-northeast-central-southeast – LOW • Terrorism premium varies • HIGH – real estate/basic materials/entertainment • LOW – Tedchnology/Consumer goods • HIGH – northeast –south – central – west – southeast • Regression (dependent variable Terrorism limit/insurable value • Demand elasticity -0.646 • coefficient for property limit/insurable value = 0.879 • Generally rational market but with many choosing non insurance • Incentive for captives – free reinsurance option – low deductible

Figure 9.2. Terrorism Limit / Property Limit by Insurable Value (478 AON accounts)

Figure 9.3. Predicted Probabilities of Purchasing Terrorism Coverage for Accounts at 25th Percentile, Mean, and 75th Percentiles of Insurable Value

Table 9.5 Regressions of Terrorism Limit / Insurable Value on Terrorism Premium Rate Relative to Property Rate and Control Variables (248 Aon accounts with any terrorism coverage and non-zero premiums)

Does market clear? continued • Generally rational market but with many choosing non insurance • Many forms absorb loss through capital structure • Some mitigate (e.g. chemical firms) • Incentive for captives – • free reinsurance option – • low deductible – captives usually have low TRIA premiums • Relatively little reinsurance • For non certified • For TRIA deductible • Difficult to forecast reinsurance in absence of no renewal • not obligated under compulsory insurance statutes

Would post-loss supply be constrained by capital shortage? • Major industry-wide shocks tend to be followed by • Shortage of capacity in ALL lines • More severe in line affected (revision of loss expectancy) and lines which demand more capital (long tail) • Demand surge in affected line • Reduced supply and increased demand cause premium spikes • Over time new capital enters to exploit hard market • High leveraged firms worst hit with some insolvencies • This is known as capacity constraint model • Evidence after Liability Crisis, Northridge, Andrew, 9/11, etc.

Would post-loss supply be constrained by capital shortage? continued Capacity constraint shows markets to be self correcting following major shocks but self correction involves some disruption – hard markets Would market be self correcting (in time) following another major terrorism attack? • Depends on climate of uncertainty • Depends on whether insurers allowed to service hard market

The Economics of Terrorism Insurance