Insurance and safety after September 11, 2001: Coming to grips with the costs and threats of terrorism

Abstract

This chapter, originally written as a consequence of the terrorist attacks of September 11, 2001, provides an elementary, everyday introduction to the concepts of risk and insurance. Conceptually, risk has two dimensions: a potential loss, and the chance of that loss being realized. People can, however, transfer risk to insurance companies against the payment of so called premiums. In practice, however, one needs accurate assessments of both losses and probabilities to judge whether premiums are appropriate. For many risks, this poses little problem (e.g., life insurance); however, it is difficult to assess risks of many other kinds of events such as acts of terrorism. It is emphasized, that through evolution and learning, people are able to handle many of the common risks that they face in life. But when people lack experience (e.g., new technologies, threats of terrorism), risk can only be assessed through imagination. Not surprisingly, insurance companies demand high prices when risks are poorly understood. In particular, the cost of insurance against possible acts of terrorism soared after September 11. How should people approach risk after the events of that day? Clearly, the world needs to protect itself from the acts of terrorists and other disturbed individuals. However, it is also important to address the root causes of such antisocial movements. It is, therefore, suggested that programs addressed at combatting ignorance, prejudice, and social inequalities may be more effective premiums for reducing the risk of terrorism than has been recognized to date.

There is clearly a need for insurance against terrorist attacks and other potentially catastrophic events. Moreover, in the developed world, markets typically arise to meet such needs. Why then, is the market for catastrophic insurance such an exception and what, if anything can or should be done about this? The fundamental reason probably lies in the fact that, in order to face potential catastrophic risks, insurance companies need to maintain large amounts of liquid capital. However, according to Dwight Jaffee and Thomas Russell12, this is not facilitated in the US by institutional factors that involve, inter alia, accounting regulations, tax laws, and the threat of takeover of companies with large cash reserves. Indeed, Jaffee and Russell state that the failure of the insurance market to provide coverage against catastrophic events is due to idiosyncracies or failures in the capital markets as opposed to problems with insurance per se. On the other hand, Howard Kunreuther has pointed out that even if potential investors are offered the chance to buy what seem like quite profitable catastrophe bonds (i.e., so-called “cat bonds”), there is considerable reluctance to do so.13 In other words, there is considerable aversion to investing in companies or financial instruments that depend on events that are characterized by large potential losses and unknown probabilities (however small the reasonable upper bounds of these probabilities might be).

In fact, many countries in the Western world now have policies whereby governments have effectively agreed to become the insurers of last resort in the case of catastrophes. This is the case, for example, in Great Britain, France and Israel although what differs between countries is the methods governments use to build up necessary funds across time, e.g., by imposing a levy on all private insurance contracts (France), a “pool” or risk-sharing appoach (UK), or specific taxes on property (Israel). As can be seen, however, the final costs of insuring against catastrophes is borne by the citizens of each country; what varies is how such costs are borne by different segments of the population. Currently (September 2002), it is this issue that is being debated in the US.

Finally, we referred above to the fact that the share prices of insurance companies rebounded quickly in the aftermath of September 11, 2001. Subsequently (through September 2002), share prices have dropped considerably along with the share prices of almost all sectors of business activity. However, it would be foolish to attribute this drop in prices on the events of September 11, 2001. Instead, it is much more indicative of the general malaise in share prices that has swept over the world economy in the last year.

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