ErwannMichel-Kerjan May 11 06

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?

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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).

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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).

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