Check Rearview Mirror On Terrorism Risks

One thing we know about mega-catastrophes is that immediatelyfollowing a mega-event, there is a major retrenchment in theprovision of insurance and reinsurance coverage.

In the United States we have the examples of Hurricanes Andrewand Iniki, the Northridge earthquake, and, of course, the events ofSept. 11. Overseas, we have examples like the United Kingdom, wherethe market for terrorism coverage evaporated after the 1993 IRAbomb attack in Londons financial district.

Obviously, perceptions of risk change immediately after a majorevent. Insurers and reinsurers see the peril in question as havinga far higher probability than previously perceived. Having fallenoff a horse, they have no intention of getting right back up on thesame horse.

The question that comes to mind of psychology theorists iswhether this phenomenon is a variation of “hindsight bias”–thetendency for people to revise the probability of future events whengiven information about a past event or experiencing onethemselves.

Regardless of how theorists explain the rearview thinking ofinsurers, the critical question for markets and policymakers iswhether this apparently inevitable negative market reaction to theterrorism risk will decrease over time, leading to the possibilityof a more widespread private market for the transfer of theterrorism exposure.

There are factors on both sides of this issue. Some factorssuggest that the perception of the terrorism risk will increaseover time, while others indicate that the fear of the risk willdecrease.

Factors on the increase side of the argument include:

The most likely factor to reinforce the market's reluctance towrite terrorism risk would be another incident. This need not be amajor event. It could be just an attempt like the Richard Reidexploding shoe attempt aboard an airplane.

A second factor is the release of information by governmentauthorities, indicating plans for further attacks by terrorists,particularly those of a catastrophic nature–for example, a suitcasenuclear device, or bio/chemical/nuclear contamination.

A third factor would be the belief by insurers that over timevigilance and security decreased, thereby increasing the likelihoodof a successful terror event.

Factors suggesting that the perception of the terrorism riskwill decrease over time include:

The history of mega-events tells us that perceptions onprobabilities tend to decrease as time passes. For example,following Hurricane Andrew, catastrophe reinsurance rates tripledon average, then in a few years dropped back to about the level ofwhere they had been prior to the event.

The war on terror is viewed as successful. The ability ofAl-Qaeda or similar terrorist organizations to conduct a majoroperation is viewed as being greatly diminished. In thiseventuality, insurers are likely to lower their estimates of lossfrom terrorism events.

Al-Qaeda or other terrorist organizations change tactics. Theyturn to less catastrophic acts. They turn more towards symbolicevents, causing little or no loss of life or property damage. Forexample, they could move to self-immolation on the U.S. Capitolsteps, or other acts in a manner not too dissimilar to theanti-government Buddhist campaign in the early 1960s in SouthVietnam.

A final factor would be the belief that the federal governmentthrough its action in creating the victims compensationfund, providing an estimated average of $1.6 million per victim,and through its inaction in not passing a federalterrorism reinsurance fund, was in effect saying that it would be a“post-event insurer” of last resort.

If a major terrorism event occurred, there is a stronglikelihood that the federal government would feel morally obligatedto step in and pay for property damage and bodily injury, since itsfailure to create a backup terrorism reinsurance pool left themarket without coverage.

If such a perception gains credence among policyholders, thedemand for the terrorism coverage is likely to decrease. Such adecrease in demand would tend to reduce the price of terrorismcoverage and make it a less attractive market in term of pricingfor insurers.

It is probably too early to judge how these factors will playout over the next year or so. Since history is often our bestguide, the better bet at this point would appear to favor adiminution in the insurance markets fear of terrorism.

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, February 25, 2002.Copyright 2002 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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