IWU News

One of the biggest concerns for insurance companies involves catastrophes. Insurers need to consider the maximum probable loss and the maximum possible loss of a disaster when pricing policies to ensure sufficient reserves are available to pay future claims.

There are companies who specialize in providing information to insurers to assist in this process. For example, in the case of hurricanes, the models developed by these firms have typically used probabilistic loss analysis to estimate the frequency and severity of hurricanes reaching land. An insurance company with a number of houses insured in south Florida and wanting to know the odds of a Category 4 Hurricane hitting the heart of Miami, Florida would find this information critical. These specialists even extend the analysis to quantify such risks as property, health, and life.

While predicting when and where the next major earthquake, tornado, or hurricane will take place is an inexact science, the models developed by these firms provide valuable data to assist insurance companies in pricing decisions. Often these firms testify before state regulators in jurisdictions that require pre-approval of rate changes.

Recently Congress passed and the President signed into law the Terrorism Risk Insurance Act of 2002. Under the provisions of the Act, all commercial property and casualty insurers are required to cover losses due to international terror activity within the United States. Insurance companies were given 90 days after the new legislation was signed to develop defensible premiums for terrorism coverage.

This has presented an interesting dilemma for the insurance industry, as determining the probability of a catastrophic risk such as terrorism is much different than natural disasters such as hurricanes and tornadoes. Unlike natural catastrophes, terrorist attacks are a function of highly variable human behavior. In addition, there are decades of weather data available to draw from when forecasting long-term weather patterns. There are basically only three prior occurrences for large-scale terrorism attacks in the United States: the 1993 bombing of the World Trade Center; the 1995 Oklahoma City bombing; and the September 11, 2001 attacks.

Fortunately, those companies who specialize in modeling for natural disasters are expanding their products to include terrorism models. AIR Worldwide Corp.’s model accounts for a wide variety of terrorist organizations (not only Al Qaeda), the weapons likely to be used by each group on each target, and the likelihood of attack on more than 300,000 potential targets, including a subset of high-profile "trophy" targets that correspond to a higher probability of attack. EQECAT Inc. uses a fully probabilistic model that covers all relevant risk sources, including bomb blast, aircraft impact, and CBNR (chemical, biological, nuclear and radiological) weapons for all 50 states.

At the heart of the model developed by Risk Management Solutions (RMS) is "game theory," a mathematical approach to situations made famous by Nobel Prize-winning economist John Nash and later popularized by the film, "A Beautiful Mind." Game theory is a model for planning under conflict. It is highly regarded for modeling a variety of circumstances, including economic behavior, geopolitical outcomes, and war games. The RMS model is focused on macro-terrorism events, which the company defines as losses of over $1 billion dollars or involving more than 500 casualties.

All three companies elicit expertise in developing their respective products from such areas as the Department of Defense, CIA, FBI, RAND Corp., and Center for the Study of Terrorism and Political Violence at the University of St. Andrews. These experts assist in the understanding of the dynamics between such factors as underlying ideologies and operational capacities of terrorist organizations, their target priorities, weapons availability, and the influence of security measures and counter-terrorism.

Insurance companies have been known to take on unusual risks that are challenging to quantify. Lloyd’s of London has been involved in accepting risks associated with Bruce Springsteen’s voice, Tina Turner’s legs, and the tasting ability of the chief taster for Dreyer’s Grand Ice Cream. However, the maximum dollar amount paid out in a worst case scenario in those policies is known and miniscule compared to the catastrophic risks of a large-scale terrorist attack. According to the Insurance Information Institute, the cost of the September 11 attacks to insurers is estimated to be around $40-50 billion. That projection dwarfs the $15.5 billion cost of Hurricane Andrew in 1992, and the $12.5 billion cost of the Northridge, CA earthquake in 1994.

This is yet another illustration of the increasing complexity of risks faced by individuals and institutions in our society. In order to provide the pooling mechanism that facilitates risk-sharing across a large group, insurers are continuing to use technology and specialized expertise to enable them to meet this need.

Tim Query, Ph.D., C.P.A., A.R.M. is an Assistant Professor of Risk Management, Insurance, and Finance at Illinois Wesleyan University.