Insurance and Terrorism

Terrorism: The Limit of Insurability

The insurability of terrorism risk poses several issues. In fact, while simplifying, two conditions must be verified for a risk to be judged insurable. The first is the capacity to identify and quantify (or to estimate) the probability of occurrence of the event to be insured against, as well as the potential losses. The second is the capacity to determine an amount of premium that actually reflects the risk level, and that will be acceptable to the insurer. If these two conditions hold, the risk can then be considered insurable. It is precisely these two conditions that are problematic in the case of the risk of terrorism. As the terrorist attacks of September 11, 2001, demonstrated, large-scale terrorism has the potential to inflict truly catastrophic losses to insurers, which could lead them into bankruptcy. Moreover, there is a lot of uncertainty about what the risk actually is, because it can evolve rapidly. More specifically, since terrorists are likely to adapt their strategy as a function of their own resources and their knowledge of the vulnerability of the entity they want to attack, the nature of the risk is continuously evolving. The likelihood and consequences of a terrorist attack are influenced by a mix of strategies and counterstrategies (e.g., anti-terrorism activities by governments and potential victims of attacks) that have been developed by a range of stakeholders and shift over time. This leads to “dynamic uncertainty,” which make insurance pricing a difficult task.

Even in cases where a risk is insurable, it does not necessarily mean that it will be a profitable activity for an insurance company, which can always decide not to cover it. This is notably the case if it is impossible to establish a price level at which the insurer will receive sufficient premiums to cover the inherent costs of its activities (e.g., product development, [Page 276]marketing, premium collection, cost of capital, claim payment), so that the product will be profitable enough to satisfy its shareholders. In some cases, the insurer can prefer not to cover certain risks, unless it is obligated to do so by law.

...