The Role of Insurance in Managing Extreme Events: Implications for Terrorism Coverage

Howard Kunreuther

Center for Financial Institutions Working Papers from Wharton School Center for Financial Institutions, University of Pennsylvania

Abstract: A key question being raised since September 11 th is the appropriate role of the private and public sectors in reducing losses and offering insurance protection against extreme risks such as natural disasters, technological accidents and terrorist activities. The following scenario illustrates the challenges and opportunities facing the insurance and reinsurance industry in this regard:

Scenario: Over the past 10 years the AllRisk (AR) Insurance Company has provided $500 million in coverage to Big Business (BB) Inc. against risks to its plant including terrorism. AR covers $100 million itself and has purchased an excess of loss reinsurance contract from Reinsurance Enterprise (RE) to cover the remaining $400 million. Given the events of Sept. 11 th RE has decided that terrorism will no longer be included in its coverage because of the uncertainties associated with the risk. BB needs terrorism coverage since the bank that holds its mortgage requires this as a condition for the loan. AR must decide whether or not to continue providing BB with the same type of insurance as it has had previously and if so how much coverage it is willing to offer.

This scenario raises the following questions that this paper will address:

1. What factors determine whether the risk is insurable?

2. How much capital will AR require in order to provide protection against extreme events?

3. What role can and should the public sector play in providing protection against extreme events?

The next section addresses Question 1 by showing that uncertainty regarding the risks is likely to raise the premiums considerably particularly if one is concerned with the potential of large losses. Section 3 addresses Question 2 by focusing on the illustrative example depicted in the scenario and showing that large amounts of capital are required to provide protection against uncertain events with large potential losses. In Section 4 I turn to Question 3 and contend that today there is a more important role for the public sector to play than ever before because of the uncertainties of the risks and the externalities associated with them. The paper concludes with a set of open questions for future research.

Date: 2001-12
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