How Should Insurers, ReinsurersSet Prices For TerrorismCoverage?

How does an insurer or reinsurer come up with a price for theterrorism peril?

For an economist, pricing is determined by the interaction ofdemand and supply. Of these two, demand is the most important.

For example, consider a farmer with an apple orchard. Hisaverage cost for growing apples and bringing them to market is 20cents per apple.

However, once he gets to the market he finds that customersvalue his sweet, fresh apples very highly and are willing to pay $1each.

So what is the market price? Obviously $1, and he pockets the 80cents as an unexpected but welcome profit windfall.

Turning then to the terrorist risk, let us look first atsupply.

For an insurance company, the supply price tends to mean theactuarial price–that is, the minimal price based on projectedlosses that should be charged for this risk.

Ones first instinct is to say that such an actuarial price isimpossible to determine in such an amorphous area as terrorism.

But, of course, insurers for centuries have been setting pricesfor many other risks where there is little or no actuarialanalysis.

For example, war risks are routinely insured in the ocean marineline. There is insurance for being hit on the head by a fallingsatellite. And, of course, there is the well-known example of BettyGrables legs, which were insured via Lloyds of London.

In terms of terrorism, one can be a little more analytical thanthe above examples.

Thus, the actuarial brains at Guy Carpenters quantitativeservice unit–Instrat–have suggested some approaches to thisquestion.

Dealing with frequency for the moment, it is believed that thefederal government has data on attempted terrorist events over along period. Given such data and informed guesses on theprobability of a successful terror attack, one could make someestimation of the probability of a terror event.

In terms of severity, one can look at the losses of variousterrorist events around the world, restate the losses in currentU.S. dollars, and calculate an average.

One could be even more creative and fit a statisticaldistribution to the losses, which could provide a sense not just ofthe average size of event, but of the relative probability of largeversus small events.

Given frequency and severity numbers, one could then calculateexpected losses, and add an appropriate expense and profit load tocome up with a minimum price.

Turning now to the demand side, the question is: What pricewould a customer be willing to pay for the transfer of thestand-alone terrorism risk?

The answer would appear to be a fair amount.

Based on congressional testimony and media stories on the needfor terror insurance to prevent significant sectors of the U.S.economy–such as real estate and construction–from grinding to ahalt, one could safely assume that commercial policyholders wouldbe willing to pay significant amounts for the terrorismcoverage.

To see the issue in more concrete terms, let us assume that thefederal government decides to supply the terrorism coverage on afull 100 percent basis, just as flood coverage is providedtoday.

How should they price the product? I would argue that they needmainly to consider the demand side.

They could set a price that is affordable to businesses, so thatthe wheels of commerce can continue to turn.

They could, for example, add a surcharge to every commercialinsurance policy. Such a surcharge should be affordable.

Many businesses in the past two years have experienced increasesin insurance premiums, which they have absorbed without unduehardship. So a reasonable surcharge would appear to be anaffordable option.

However, the federal “terror insurance” czars would need to takea peek at the supply side. They should want to make sure that theprice they charge is sufficient to attract private capacity backinto the market once the panic subsides and there is a clearersense of the state of domestic security.

In fact, by setting a fair price they would encourage thedevelopment of a private terrorism insurance market, leadinghopefully to the eventual demise of the federal role.

As the debate continues in the halls of Congress and elsewhere,one can expect that many more approaches will be developed toaddress the pricing issues.

However, one principle should be kept paramount: Demand is thekey consideration in setting prices, not supply.

Sean F. Mooney, CPCU, is senior vice president, researchdirector and economist at Guy Carpenter & Company in NewYork.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, November 26, 2001.Copyright 2001 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.

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