Managing and Financing Extreme Events: The Case of Terrorism Erwann O. MichelKerjan
erwannmk@wharton.upenn.edu Managing Director Center for Risk Management and Decision Processes The Wharton School University of Pennsylvania
Terrorism Tomorrow: The Impact on You, your Life and your Money The Global Interdependence Center May 11, 2006
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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 2
“Homeland security is the concerted effort to prevent 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 Component Who 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 largescale attack? What is the best way for a firm to recover from a largescale attack? 4
When Finance Meets National Security Federal Government Policies COUNTER TERRORISM POLICY
ECONOMIC STIMULATION AND VICTIM COMPENSATION
FOREIGN POLICY
Who Will Pay?
Securitize
Insure
Mitigate Risk
Transfer losses to counterparty
Private Sector Policies
Transfer to lenders, etc.
Absorb losses through firm’s own capital
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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 6
Insurance today • Insurance is everywhere • With $3.3 trillion in revenues in 2005, insurance is the largest industry in the world (twice as large as the oil industry) – it would be the 3rd economy in terms of GDP • A very resilient service ... but now confronted with a totally new dimension of catastrophic risks
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Worldwide Evolution of Insured Catastrophic Losses, 19702005 85 80 75 70 65 60 55 50 45 40 35 30 25 20 15 10 5
Human-caused catastrophes
Natural catastrophes
(Property and business interruption (BI); in U.S.$ billon indexed to 2004) Sources: Wharton Risk Center with data from Swiss Re and Insurance Information
9/11/2001 attacks
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20 05
20 04
20 03
20 02
20 01
20 00
19 99
19 98
19 97
19 96
19 95
19 94
19 93
19 92
19 91
19 90
19 89
19 88
19 87
19 86
19 85
19 84
19 83
19 82
19 81
19 80
19 79
19 78
19 77
19 76
19 75
19 74
19 73
19 72
19 71
19 70
0
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)
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
Rank
9
Sources: Wharton Risk Center with data from Swiss Re, Insurance Information Institute and press releases (*estimations)
USA
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 10
Natural Hazards versus Terrorism Risks Why Is Terrorism Different? Historical Data
Natural Hazards Potential catastrophic losses
Terrorism Risks Potential catastrophic losses
Some historical data
Very limited historical data 9/11 events were the first megaterrorist attack
Risk of Occurrence
Risk reasonably wellspecified
Considerable ambiguity of risk Terrorists can intentionally adapt their strategy depending on their information on vulnerabilities;
Geographic Risk
Specific areas at risk
Information
Information sharing
Asymmetry of information
New scientific knowledge on natural hazards can be shared with all the stakeholders.
Governments keep secret new information on terrorism for obvious national security reasons.
Natural event
Resulting event
Event Type: Interdependent Security
All areas at risk Some cities may be considered riskier than others, but terrorists may attack anywhere, at any time.
To date no one can influence the Governments can influence terrorism (e.g., foreign occurrence of an extreme natural event policy; international cooperation; national security (e.g., earthquake). measures). 11
Evolution of Terrorism Threats • From leftist/politicaloriented groups operating mainly at a national level to extremistreligiousbased groups operating internationally seeking to inflict fear, masscasualties 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 12
Nature of Terrorism Insurance Pre and Post9/11 Prior to September 11, 2001 Terrorism coverage in the United States was included in standard commercial insurance policy packages as an unnamed peril
Terrorist attacks of September 11, 2001
The most costly event in the history of insurance up to that point Insured damage currently estimated at $35 billion, covered by 150 insurers and reinsurers worldwide Global interdependence of insurance markets Reinsurers responsible for 2/3 of the $35 billion in claims – Mostly European
On 9/11/2002, the US was largely uncovered
45 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 13
Special Features of TRIA
(Terrorism Risk Insurance Act of 2002) A 3year 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 risksharing arrangement between government and insurers Domestic terrorism (e.g., 1995 Oklahoma bombing) is not covered 14
Loss Sharing under TRIA between Insurance Industry, All Policyholders and Taxpayers (2006) Taxpayers
Total Insured Loss
Commercial Policyholders Insurers
L
Taxpayers Industry retention ($25bn)
Total initial federal payment:
∑90%( L
i
i
All commercial policyholders
(
Total insurance payments = ∑ Min( Li ; IDi ) + 10%( Li − IDi ) i
+
)
15
− IDi )
+
Agenda 1. When Insurance & Finance Meet Homeland Security 2. Managing and Financing Extreme Events: A New Era 3. Why is Terrorism Different from other catastrophes? The US response: TRIA 4. The Wharton Risk Center’s initiative on terrorism insurance: a few points of discussion based on plausible scenarios of attacks 16
Wharton Risk Center Initiative on Terrorism Risk Financing 10month work (2005); 240 pages A 9person team directed by Kunreuther and MichelKerjan Collaboration with nearly 100 organizations in the US and abroad Support document for Congress “One of the best studies on terrorism insurance and TRIA” The Economist, November 2005
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Who bears the costs of a terrorist attack under TRIA? Chapter 6 of TRIA and Beyond • Constructing scenarios of attack in 477 highrises in the US • Two types of attacks (truck bomb and aircraft) • Two lines of coverage (property and workers’ comp, WC) • Hypothesis Property (including BI): 50% of the firms bought terrorism insurance (current estimate) – Workers’ comp is 100%
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$bn
Property Losses and Workers’ Compensation Losses from 5Ton Bomb Attacks to 447 High Rise Buildings in the United States 8 C
7
B
WC Loss
6 5 A 4 3 2 1 0 0
1
Sources: Wharton Risk Center
2
3
4
5
6
Property Loss
7
8
9
10
$bn
19
Property Losses and Workers’ Compensation Losses from Aircraft Attacks to 447 High Rise Buildings in the United States 3
WC Loss
2
1
0 0
1
Sources: Wharton Risk Center
2
3
4
5
6
Property Loss 20
7
8
Other scenarios • Anthrax attack on NYC ($4060bn; worker’s compensation and business interruption) • Attack on a major port (major interdependencies worldwide due to justintime global supply chains; >$100bn) • Challenge: Use of our own critical infrastructure against us (9/11: air transportation; anthrax: postal operation; Madrid: trains) 21
How does the Location of the attack affect losssharing? E.g., $25 billion losses due to two 5ton truck bombs Loss Sharing City Comparison
New York, NY
Non insured
Total insured
$7.5bn $17.5bn % total insured
Houston, TX
All Policyholders
Fed. Gov Taxpayers
$1.73bn
$2.5bn
76%
10%
14%
$13.1bn
$1.9bn
$2.5bn
75%
11%
14%
$14.5bn
$0.5bn
$2.5bn
83%
3%
14%
$7.5bn $17.5bn $13.27bn % total insured
Los Angeles, CA
Insurers’ Payments
$7.5bn $17.5bn % total insured
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Impact of Varying Losses from Attacks on New York City TRIA 2005 versus TRIA 2006
50% Insurance for Property Coverage; 100% for Workers’ CompensationWC
Loss Scenarios
Non insured
Loss Sharing Total insured
Insurers’ Payments
All Policyholders
Fed. Gov (Taxpayers)
(with terrorism coverage or not)
Total: $0.5bn
$125mi
$375mi
$375mi [$375mi]
$0 [$0]
$0 [$0]
100%
0%
0%
% total insured in 2005
$13.27bn [$13.27bn] 75.9%
$1.73bn [$4.23bn] 9.9%
$2.5bn [$0] 14.2%
% total insured in 2006
75.9%
[24.1%]
[0%]
% total insured in 2005
$20.6bn [$20.6bn] 79.2%
$0 [$4.4bn] 0%
$5.4bn [$1.0bn] 20.8%
% total insured in 2006
[79.2%]
[16.9%] 23 $0
[3.9%]
Property: $0.25bn -WC: $0.25bn
% total insured 2005 and 2006 (identical)
Total: $25bn
$7.5bn
$17.5bn
Property: $15bn - WC: $10bn
Total: $40bn
$14bn
$26bn
Property: $28bn - WC: $12bn
Total: $100bn
$25bn
$75bn
$34.1bn
$40.9bn
Summary and Conclusions 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) 24
Open Questions Is the probability of a largescale attack on US soil in the next 4 years higher than it was in the past 4 years? Where?
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 Clevel)
Is the Nation ready?
stablished a National Strategy for Physical Protection of Critical Infrastruc a National Strategy to Secure Cyberspace; but we still don’t have
a National Strategy for Financial Protection 25
Contact Information Erwann O. MichelKerjan, Ph.D. The Wharton School University of Pennsylvania Jon M. Huntsman Hall, room 556 3730 Walnut Street Philadelphia, PA 19104 Voice: 2155730515 Email: erwannmk@wharton.upenn.edu Wharton TRIA and Beyond study available at: http://grace.wharton.upenn.edu/risk/newresearch.html 26
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 PublicPrivate 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). 27