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Managing and Financing Extreme Events:

The Case of Terrorism

Erwann O. Michel-Kerjanerwannmk@wharton.upenn.edu

Managing DirectorCenter for Risk Management and Decision Processes

The Wharton SchoolUniversity of Pennsylvania

Terrorism Tomorrow: The Impact on You, your Life and your Money

The Global Interdependence CenterMay 11, 2006

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Agenda1. When Insurance & Finance Meet

Homeland Security

2. Managing and Financing Extreme Events: A Totally New Era

3. Why is Terrorism Different from other catastrophes? The US response: TRIA

4. The Wharton Risk Center’s initiative on terrorism insurance: a few points of discussion based on plausible scenarios of attacks

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“Homeland security is the concerted effort toprevent attacks, reduce America’s vulnerability to terrorism, and minimize the damage and recover from attacks that do occur”

-The White House, July 2002

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The Recovery ComponentWho will (should) pay for the

economic consequences of the next terrorist attack?

OR

What is the best way for the Nation to recover from a large-scale

attack?

What is the best way for a firm to recover from a large-scale attack?

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FOREIGN POLICYCOUNTER TERRORISM POLICY

Federal Government Policies

Private Sector Policies

Mitigate Risk Transfer losses to counterparty

Absorb losses through firm’s own

capital

Securitize Insure Transfer to lenders, etc.

Who Will Pay?

ECONOMIC STIMULATION AND

VICTIM COMPENSATION

When Finance Meets National Security

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Agenda

1. When Insurance & Finance Meet Homeland Security

2. Managing and Financing Extreme Events: A Totally New Era

3. Why is Terrorism Different from other catastrophes? The US response: TRIA

4. The Wharton Risk Center’s initiative on terrorism insurance: a few points of discussion based on plausible scenarios of attacks

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Insurance today

• Insurance is everywhere

• With $3.3 trillion in revenues in 2005, insurance is the largest industry in the world (twice as large as the oil industry) – it would be the 3rd economy in terms of GDP

• A very resilient service ... but now confronted with a totally new dimension of catastrophic risks

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Worldwide Evolution of Insured Catastrophic Losses, 1970-2005

(Property and business interruption (BI); in U.S.$ billon indexed to 2004)Sources: Wharton Risk Center with data from Swiss Re and Insurance Information

Institute

0

5

1015

20

25

30

35

4045

50

55

60

65

7075

80

85

Human-caused catastrophes Natural catastrophes 9/11/2001 attacks

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The 20 Most Costly Insurance Losses Due To Catastrophe, 1970-2005

(19 of them since 1990; 10 of them occurred in the last 5 years) Rank U.S.$ Billion

(indexed to 2004) Event Victims (Dead and missing) Year Country

1 40-55 Hurricane Katrina 1,281* 2005 USA

2 32.4 9/11 Attacks 3,025 2001 USA

3 21.50 Hurricane Andrew 43 1992 USA, Bahamas

4 17.80 Northridge Quake 61 1994 USA

5 11.00 Hurricane Ivan 124 2004 USA, Caribbean et al

6 8.00 Hurricane Charley 24 2004 USA, Caribbean et all

7 7.80 Typhoon Mireille 51 1991 Japan

8 6.7 Winterstorm Daria 95 1990 France, UK et al

9 6.6 Winterstorm Lothar 110 1999 France, Switzerland et al

10 6.4 Hurricane Hugo 71 1989 Puerto Rico, USA et al

11 4-7 Hurricane Rita 119 2005 USA

12 5.0 Hurricane Frances 38 2004 USA, Bahamas

13 5.0 Seaquake, Tsunami 280,000 2004 Indonesia, Thailand et al

14 5.0 Storms and floods 22 1987 France, UK et al

15 4.6 Winterstorm Vivian 64 1990 Western/Central Europe

16 4.6 Typhoon Bart 26 1999 Japan

17 4.1 Hurricane Georges 600 1998 USA, Caribbean

18 4.0 Hurricane Jeanne 3,034 2004 USA, Caribbean et al

19 3.6 Typhon Songda 45 2004 Japan, South Korea

20 3.4 Tropical Storm Alison 41 2001 USASources: Wharton Risk Center with data from Swiss Re, Insurance Information Institute and press releases (*estimations)

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Agenda

1. When Insurance & Finance Meet Homeland Security

2. Managing and Financing Extreme Events: A Totally New Era

3. Why Is Terrorism Different from other Catastrophes? The US response: TRIA

4. The Wharton Risk Center’s initiative on terrorism insurance: a few points of discussion based on plausible scenarios of attacks

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Natural Hazards versus Terrorism RisksWhy Is Terrorism Different?

Natural HazardsPotential catastrophic

lossesTerrorism Risks

Potential catastrophic losses

Historical Data

Some historical data Very limited historical data9/11 events were the first mega-terrorist

attack

Risk of Occurrence

Risk reasonably well-specified

Considerable ambiguity of risk

Terrorists can intentionally adapt their strategy depending on their information

on vulnerabilities;

Geographic Risk

Specific areas at risk All areas at riskSome cities may be considered riskier than others, but terrorists may attack anywhere, at any time.

Information Information sharingNew scientific knowledge on

natural hazards can be shared with all the stakeholders.

Asymmetry of informationGovernments keep secret new

information on terrorism for obvious national security reasons.

Event Type:Interdepend

entSecurity

Natural eventTo date no one can influence the occurrence of an extreme natural event (e.g., earthquake).

Resulting eventGovernments can influence terrorism (e.g., foreign policy; international cooperation; national security measures).

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Evolution of Terrorism Threats• From leftist/political-oriented groups operating

mainly at a national level to extremist-religious-based groups operating internationally seeking to inflict fear, mass-casualties and maximum economic disruption to western nations

• The world’s 14 worst terrorist attacks (based on the number of casualties) all occurred after 1982. 3/4 took place between 1993 and 2004.

• As security increases at government places (embassy, etc), targets have switched to business and public operation

In 2000, 85% of attacks against US interests in the world was against enterprises - It was 90% in 2001

Economic impacts take center stage

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Nature of Terrorism InsurancePre- and Post-9/11

Prior to September 11, 2001Terrorism coverage in the United States was included in standard commercial insurance policy packages as an unnamed peril

On 9/11/2002, the US was largely uncovered45 states in the U.S. permitted insurance companies to exclude terrorism from their policies (except WC)Terrorism Risk Insurance Act (TRIA) passed by Congress in Nov. 2002

Terrorist attacks of September 11, 2001The most costly event in the history of insurance up to that pointInsured damage currently estimated at $35 billion, covered by 150 insurers and reinsurers worldwide - Global interdependence of insurance marketsReinsurers responsible for 2/3 of the $35 billion in claims – Mostly European

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Special Features of TRIA (Terrorism Risk Insurance Act of 2002)

A 3-year temporary system covering up to $100bn; renewed at the last minute in December 2005 for 2 years

All insurers required to offer coverage to their commercial policyholders

Policyholders have freedom to accept coverage

Free upfront government reinsurance, but government can partially recoup its payment ex post against all policyholders

Specific risk-sharing arrangement between government and insurers

Domestic terrorism (e.g., 1995 Oklahoma bombing) is not covered

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Loss Sharing under TRIA between Insurance Industry,

All Policyholders and Taxpayers (2006)  

All commercial policyholders

i

iiii IDLIDLMinpaymentsinsuranceTotal %10);(

Total initial federal payment:

i

ii IDL%90

Taxpayers

CommercialPolicyholders

Insurers

Total Insured Loss

Industryretention ($25bn)

Taxpayers

L

All commercial policyholders

i

iiii IDLIDLMinpaymentsinsuranceTotal %10);(

Total initial federal payment:

i

ii IDL%90

Taxpayers

CommercialPolicyholders

Insurers

Total Insured Loss

Industryretention ($25bn)

Taxpayers

L

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Agenda

1. When Insurance & Finance Meet Homeland Security

2. Managing and Financing Extreme Events: A New Era

3. Why is Terrorism Different from other catastrophes? The US response: TRIA

4. The Wharton Risk Center’s initiative on terrorism insurance: a few points of discussion based on plausible scenarios of attacks

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Wharton Risk Center Initiative on Terrorism Risk Financing

10-month work (2005); 240 pages

A 9-person team directed by Kunreuther and Michel-Kerjan

Collaboration with nearly 100 organizations in the US and abroad

Support document for Congress

“One of the best studies on terrorism insurance and TRIA” The Economist, November 2005

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Chapter 6 of TRIA and Beyond• Constructing scenarios of attack in 477 high-rises in

the US

• Two types of attacks (truck bomb and aircraft)

• Two lines of coverage (property and workers’ comp, WC)

• Hypothesis - Property (including BI): 50% of the firms bought terrorism insurance (current estimate) – Workers’ comp is 100%

Who bears the costs of a terrorist attack under TRIA?

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Property Losses and Workers’ Compensation Losses from 5-Ton Bomb Attacks to 447 High

Rise Buildings in the United States

0

1

2

3

4

5

6

7

8

0 1 2 3 4 5 6 7 8 9 10

$bn

$bnProperty Loss

WC

Los

s

A

C B

Sources: Wharton Risk Center

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0

1

2

3

0 1 2 3 4 5 6 7 8Property Loss

W

C L

oss

Property Losses and Workers’ Compensation Losses from Aircraft Attacks to 447 High Rise

Buildings in the United States

Sources: Wharton Risk Center

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Other scenarios

• Anthrax attack on NYC ($40-60bn; worker’s compensation and business interruption)

• Attack on a major port (major interdependencies worldwide due to just-in-time global supply chains; >$100bn)

• Challenge: Use of our own critical infrastructure against us (9/11: air transportation; anthrax: postal operation; Madrid: trains)

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Loss SharingCity

ComparisonNon-

insured

Total insure

d

Insurers’

Payments

All Policyholde

rs

Fed. GovTaxpayers

New York, NY

$7.5bn

$17.5bn

$13.27bn

$1.73bn $2.5bn

% total insured 76% 10% 14%Los Angeles, CA

$7.5bn

$17.5bn

$13.1bn

$1.9bn $2.5bn

% total insured 75% 11% 14%Houston, TX $7.5b

n$17.5

bn$14.5b

n$0.5bn $2.5bn

% total insured 83% 3% 14%

How does the Location of the attack affect loss-sharing?E.g., $25 billion losses due to two 5-ton truck bombs

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Impact of Varying Losses from Attacks on New York City

TRIA 2005 versus TRIA 200650% Insurance for Property Coverage; 100% for Workers’ Compensation-WC

Loss SharingLoss

Scenarios Non-

insuredTotal insure

d

Insurers’Payments

All Policyholder

s(with terrorism coverage or not)

Fed. Gov(Taxpayer

s)

Total: $0.5bnProperty: $0.25bn -WC: $0.25bn

$125mi $375mi

$375mi[$375mi]

$0[$0]

$0[$0]

% total insured 2005 and 2006 (identical)

100% 0% 0%

Total: $25bnProperty: $15bn - WC: $10bn

$7.5bn $17.5bn

$13.27bn[$13.27b

n]

$1.73bn[$4.23bn]

$2.5bn[$0]

% total insured in 2005 75.9% 9.9% 14.2%% total insured in 2006 75.9% [24.1%] [0%]

Total: $40bnProperty: $28bn - WC: $12bn

$14bn $26bn $20.6bn[$20.6bn]

$0[$4.4bn]

$5.4bn[$1.0bn]

% total insured in 2005 79.2% 0% 20.8%% total insured in 2006 [79.2%] [16.9%] [3.9%]

Total: $100bnProperty: $50bn - WC: $50bn

$25bn $75bn $34.1bn[$34.1bn]

$0[$0]

$40.9bn[$40.9bn]

% total insured in 2005 and 2006 (identical)

45.5% 0% 54.5%

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Terrorism is a highly uncertain risk and hence presents insurability problems

 

Under current TRIA structure private sector covers most losses from terrorist attacks - “Only” 50% of commercial enterprises are covered

TRIA in its current form is not an efficient and equitable solution to the terrorism problem (equity issues)

Should the Private Sector Alone Pay $25bn before the fed step in?

Difficulty to quantify the risk, then to price coverage Limited capacity to cover large losses (Limited reinsurance and

Reluctance of capital markets to provide protection  via cat bonds)

Summary and Conclusions

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Is the probability of a large-scale attack on US soil in the next 4 years higher than it was in the past 4 years? Where?

Open Questions

Is the Nation ready?We established a National Strategy for Physical Protection of Critical Infrastructure,

a National Strategy to Secure Cyberspace; but we still don’t have a National Strategy for Financial Protection

Are you ready?When was the last time the firm’s –direct

and interdependent – exposure to terrorism and other extreme events was discussed on

the board’s agenda? (physical protection, financial coverage and legal

responsibility of the C-level)

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Contact InformationErwann O. Michel-Kerjan, Ph.D.

The Wharton SchoolUniversity of Pennsylvania

Jon M. Huntsman Hall, room 5563730 Walnut Street

Philadelphia, PA - 19104Voice: 215-573-0515

Email: erwannmk@wharton.upenn.edu

Wharton TRIA and Beyond study available at: http://grace.wharton.upenn.edu/risk/newresearch.html

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Selected Recent References

Looking Beyond TRIA: A Clinical Examination of Potential Terrorism Loss Sharing, National Bureau of Economic Research, (with H. Kunreuther), March 2006, Boston. A New Era calls for a New Model, International Herald Tribune, November 1, 2005.

The Challenge of Protecting Critical Infrastructure, Issues in Sciences and Technology, The National Academy of Sciences, (with P. Auerswald, L. Branscomb, T. LaPorte), October 2005, Washington, DC.

Insurability of (Mega)-Terrorism. Challenges and Perspectives. Report for the OECD Task Force on Terrorism Insurance. Organization for Economic Cooperation and Development, (with H. Kunreuther), July 2005, Paris.

Terrorism Insurance 2005. Where do we go from here?, Regulation Magazine, The CATO Institute, (with H. Kunreuther), Spring 2005, Washington, DC.

Extending Catastrophe Modeling to Terrorism, in Catastrophe Modeling: A New Approach to Managing Risk, (with H. Kunreuther and B. Porter), Springer, 2005, New York.

“PolicyWatch: Challenges for Terrorism Risk Coverage in the United States”. Journal of Economic Perspectives, (with H. Kunreuther), Fall issue. Terrorism Risk Coverage after 9/11: A Comparison of New Public-Private Partnerships in France, Germany and the U.S.” Geneva Papers on Risk and Insurance, (with B. Pedell), (2005). (includes discussion on the UK and Spain).