Corporate Risk Management and the Perception of Terrorism Risk: The Case of Germany

1. Corporate Risk Management and the Perception of Terrorism Risk:The Case of Germany Christian Thomann* J.-Matthias Graf von der Schulenburg Bruno Gas Razvan Pascalau* *U of Alabama Quebec, August, 6th, 2007

2. Research Question • How do corporations learn about dynamic risks? • Terrorism Risk is highly dynamic, potentially catastrophic and not well known • It thus provides for an opportunity to: • Test if Prospective Reference Theory (Viscusi, 1989) can be applied in a corporate context • Learn how the inflow of new information changes a corporation‘s risk management • Understand how corporations weigh new information

3. Overview Introduction: Terrorism, Insurance and Extremus Dataset Corporate Risk Attitudes andIndividual Risk Perception Hypotheses and Empirical Investigation Conclusion

4. Overview Introduction: Terrorism, Insurance and Extremus Dataset Corporate Risk Attitudes andIndividual Risk Perception Hypotheses and Empirical Investigation Conclusion

5. TerrorismA definition An Act of Terrorism means an act of any person acting on behalf of or in connection with any organisationwith activities directed towards the overthrowing or influencing of any government de jure or de facto by forceor violence. Reinsurance (Acts of Terrorism) Act 1993

6. Terrorism has changed • Old Terrorism (Wilkinson 1986, Hoffman 1992) • Motivation: Separation, Nationalism, Marxist Ideology, Economic Inequality, Goals are well defined • Organizational Structure: Command and Control. Terrorists are trained and are committed full-time to their cause • New Terrorism (Enders and Sandler 2000, Hoffman 1997) • Motivation: Less comprehensible, embrace amorphous religious aims • Organizational Structure: International networks that can be diffuse and spontaneous. Terrorists may live normal lives • Terrorism in its present form poses a new and significant challenge to Risk Managers

7. Dynamics of TerrorismHomeland Security Advisory System

8. Dynamics of TerrorismHomeland Security Advisory System

9. Assessing Terrorism Risk • Difficult to assess risk of a terrorist attack • GAO (2004): Homeland Security Advisory System: No explicit criteria or quantifiable factors are used to determine the treat level. Threat levels include a certain amount of subjectivity • Fischhoff et al. (2003): Individuals significantly overestimate their exposure to terrorism risk: • 11/2001: 43 % (19 %) of respondents living within (outside) a 100 miles of the WTC: 50 % or higher chance of themselves being hurt in a terrorist attack. • In Addition: Information provided by governments and media is likely to be biased

10. Terrorism and Insurance • Before 9/11 Terrorism is commonly included in Standard Insurance Policies • 9/11 • Highest Insured Loss Due to Terrorism • Results in Exclusion of Terrorism from Standard Insurance Contracts • Governments Intervene on Terrorism insurance markets • United States (TRIA) • Germany (Extremus) • France (GAREAT) • Interventions in Germany and US must be prolonged in 2007

11. Terrorism Insurance in Germany After September, 11th Government Intervention: Primary Insurer (EXTREMUS) Cover • Risks > 25 million € • Buildings, Content, Business Interruption and Clean up Costs Exclusions • NBC, War, ... Limit for Compensation: 1.5 bn € 100 % reinsurance by insurance industry & German Government

12. Overview Introduction: Terrorism, Insurance and Extremus Dataset Corporate Risk Attitudes andIndividual Risk Perception Hypotheses and Empirical Investigation Conclusion

13. Data SetOverview • Data on all government-reinsured terrorism insurance purchases between 11/2002 and 3/2007 in Germany (n>5000) • Name, Industry and Location of Policyholders • Amount of Coverage Purchased • Price of Insurance Coverage • Start and End of Insurance Coverage

14. Data Set, Descriptive StatisticsPolicyholder

15. Data Set, Descriptive StatisticsBy Industry and Year

16. Data Set, Descriptive StatisticsBy Industry and Year

17. Data Set, Descriptive StatisticsBy Month

18. Data Set, Descriptive StatisticsBy Month

19. Overview Introduction: Terrorism, Insurance and Extremus Dataset Corporate Risk Attitudes andIndividual Risk Perception Hypotheses and Empirical Investigation Conclusion

20. Corporate Risk Management Modigliani and Miller (1958) Mayers and Smith (1982), Stulz (1984), Froot, Scharfstein, and Stein (1993) • Greater Efficiency in the allocation of risk among a company‘s stakeholders • Bankruptcy Costs / Costs of financial distress • Taxes • Agency Problems  Corporations act as if they were risk averse

21. Corporate Risk ManagementEmpirical Studies and Extension • CRM: Empirical Studies (Insurance): • Mayers and Smith (1990), Hoyt and Khang (2000), Kleffner and Doherty (1996), Cole and McCollough (2006) • CRM and Bankruptcy: Marin (2007) • CRM: Extension to Ambiguous Risks: • Kunreuther et al. (1995): Ambiguity aversion describes prices set by insurance underwriters. • CRM of dynamic risks: has not been analyzed empirically Further Similarities between individuals’ and corporations’ behavior

22. Prospective Reference TheoryAssessing Dynamic Risks • Viscusi (1989): Prospective Reference Theory • Generalization of the EU model • Decision makers assess Probability with a Bayesian process • Empirically tested Viscusi and Evans (2006), Viscusi and O’Connor (1984) • Posterior Probability (p*) is the weighted average of: • Prior Probability q (weight: γ) • Probability p of the outcome observed (weight: ξ= number of trials)

23. Overview Introduction: Terrorism, Insurance and Extremus Dataset Corporate Risk Attitudes andIndividual Risk Perception Empirical Investigation Conclusion

24. Events Studied

25. Time Series Models

26. OLS Estimates

27. OLS Estimates

28. Results • Coefficients for the dummy Attack-variables are not significant • Yet terrorists’ activity during the previous 12 months has a significant influence and apparently not declining importance on the demand for terrorism insurance: • Interaction terms are positive and significant. • Negative coefficient for the JANUARY variable: Captures the drop in demand that resulted from the absence of major terrorist attacks between November 2002 and January 2004.

29. Further Evidence • The data on the renewal of policies also supports the importance of recent terrorist activity for the demand for terrorism insurance in Germany

30. Overview Introduction: Terrorism, Insurance and Extremus Corporate Risk Attitudes andIndividual Risk Perception Hypotheses and Empirical Investigation Conclusion

31. Conclusion Corporations’ Risk Assessments are very dependent upon recent experience with dynamic risks Overweighing of recent events will be a serious obstacle for the development of a private insurance markets against highly dynamic risks Necessary to model corporate management of dynamic risks with the help of concepts that allow for dynamic updating

32. Terrorism Insurance Expectations and Experience in Germany When Extremus was founded in 2002 its shareholders expected to generate premium income of € 250 millions.

33. Thank you

34. Results Recent Terrorist Activity has a strong and not declining importance for a company’s insurance decision. The demand for terrorism insurance decreases in the absence of terrorist attacks Recent terrorist attacks stabilize the demand for terrorism insurance When making Risk Management Decisions Corporations place a great and not declining weight on their recent experience with terrorism risk. Necessary to model corporate management of dynamic risks with the help of concepts that allow for dynamic updating

35. Corporate Risk ManagementEmpirical Studies and Extensions Mayers and Smith (1990)Demand for reinsurance by US insurers Hoyt and Khang (2000)Corporate demand for primary insurance (US) Kleffner and Doherty (1996) Supply of earthquake insurance in California McCollough/ McCollough/

36. Terrorism InsuranceExperience in Germany and the U.S.

37. Terrorismus Definition „Terrorakte sind jegliche Handlungen von Personen oder Personengruppen zur Erreichung politischer, religiöser, ethnischer oder ideologischer Ziele, die geeignet sind, Angst [...] in [...] Teilen der Bevölkerung zu verbreiten und dadurch auf eine Regierung oder staatliche Einrichtungen Einfluss zu nehmen.“ Extremus Allgemeine Bedingungen für die Terrorversicherung

38. Absence of Terrorism InsuranceEconomic Effects Hubbard et al. 2005 • Absent Major Attack: “…GDP may be $ 53 billion (0.4 %) lower, household net worth may be $ 512 billion (0.9 %) lower, and roughly 326,000 (0.2 %) fewer jobs may be created.” • In Case of an Attack “… tens of thousands more jobs could be lost due to the lack of insurance coverage and thousands of additional bankruptcies could occur compared to the 9/11 event, which was covered by the insurance industry.”

39. Individual Risk Perception Individual’s perception of risk not systematically governed by probability of event: Biases • Overestimation of Dread Risk, Unknown Risk(Slovic, 1987) Probabilities • Assessed with Availability Heuristic(Tversky and Kahneman, 1973)

42. Data Set, Descriptive StatisticsNumber of Policies Sold by Month

43. Data Set, Descriptive StatisticsNumber of Policies Sold by Month

44. Terrorism • Terrorism is the premeditated use, or threat of use, of extra-normal violence or brutality to gain a political objective through intimidation or fear against a targeted audience (United States Department of State, 2000)

45. International Terrorist Attacks1990-2003 Source: US Department of State

46. Extremus Market Penetration in Germany

47. „Omar, I think the boat is not going straight“ PrivatePublic Partnership

48. Terrorism and Insurance After September 11th, 2001 Terrorism has been excluded from many standard insurance contracts Terrorism poses significant problems for insurers: • Dynamic Uncertainty • Asymmetric Distribution of Information between Government and Private Sector • Potential of Catastrophic Losses