The attacks of 9/11 showed vividly that terrorism posed a series of challenges that set it apart from the natural and technological disasters Kunreuther had previously studied. It defied the models of probability since it was impossible to know when, where, and how the next attack would occur; it was much more difficult to protect against than, for example, a hurricane, because terrorists could react to mitigation measures; and it showed that a terrorist target can be made vulnerable by weaknesses in connected components of the system in which it operates—a theory he called interdependent security.

Kunreuther developed this theory with Dr. Geoffrey Heal of Columbia University while he was there on sabbatical during the 2001-2002 academic year, having arrived one week before 9/11. The World Trade Towers collapsed partly because of weaknesses in security-screening at Boston’s Logan Airport, where the 9/11 hijackers boarded the planes. Similarly, the bag containing the bomb that downed PanAm Flight 103 in 1988 was first loaded onto another airline in Malta and then transferred to the PanAm plane without further screening. These events illustrated that a system is only as secure as its weakest link.

“Even an airline with an infallible screening system is at risk, since only bags checked by passengers who initiate their trip with that airline are inspected,” he wrote in an article with Heal and Peter Orszag that appeared as a Brookings Policy Brief in October 2002. “The knowledge that investing in screening still leaves an airline vulnerable unless others do likewise reduces the attractiveness of investing in screening.”

The theory of interdependent security implies that insurers cannot offer lower rates to clients who attempt to mitigate their risk because those actions may be negated by a connected, if distant, entity.

Insurers attempting to estimate terrorism risk are hampered by a series of challenges that don’t apply to natural catastrophes such as earthquakes or hurricanes. Enough is known about the nature and timing of natural events to allow credible models to be developed and insurers to gauge their risk. But terrorism is unpredictable in terms of its motivation, impact, timing, and location, and whatever knowledge is possessed about the activities of terrorist groups is closely guarded by government, rather than being available to the computer-modeling companies on which insurers normally rely.

In an effort to assess the risk of terrorist attack, modeling companies have taken several different approaches that are described in Catastrophe Modeling: A New Approach to Managing Risk, a 2005 book edited by Kunreuther and Patricia Grossi, with contributions by the three major modeling companies: EQECAT, Risk Management Solutions, and AIR Worldwide Corporation.

But even the modelers acknowledge the shortcomings of their craft when it comes to terrorism. “There’s a healthy skepticism by the insurance companies toward models of terrorism,” says Kuzak of EQECAT. “There’s a substantially greater uncertainty for terrorism than there is for natural hazards—the models for insured losses are not so good.”

If TRIA is allowed to expire and no similar program is put in its place, premiums will soar, and many firms are unlikely to protect themselves with insurance because of the high cost of coverage and fading memories of 9/11, many industry participants believe. That situation would persist until after the next terrorist attack, when the federal government will come under pressure to compensate uninsured victims, as it did after the Alaska earthquake in 1964 and many other natural disasters since then. Many insurers will withdraw from the market, as they did immediately after 9/11, because of uncertainties over risk and fear of future ruinous losses.

But a purely government program would also have limitations because it would exclude the expertise, the financial resources, and the operational capacity of the insurance industry.

A public-private partnership appears to offer the best chance of working, Kunreuther believes. “For those who recognize terrorism risk coverage as an important tile in the mosaic of national security, the specific characteristics of terrorism risk call for federal participation,” he has written.

The essential challenge is to spread the risk appropriately among the insured parties, the industry, the capital markets, and the government. And given the unique nature of the challenge, the government has capabilities that the private sector lacks, Kunreuther argues. The public sector can diversify the risks through the tax system to the entire population and even spread losses to future generations of taxpayers.

Concerned parties need to examine ways for the public sector to form a sustainable partnership with the insurance industry to provide terrorism insurance, perhaps by offering reinsurance, as it does now, or by covering certain losses from terrorism that are beyond the capacity of the industry, he says. Government may also be able to encourage better risk-mitigation efforts by linking terrorism insurance to protective measures through well-enforced standards and regulations.

Whatever the eventual solution, failure to create the right conditions for a viable terrorism insurance market could have dire consequences, Kunreuther warns. “If nothing coherent is done should TRIA expire, another large terrorist attack could have a much greater financial and social impact than what the nation experienced after September 11.”

Jon Hurdle is a freelance journalist based in Ambler, Pennsylvania.

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©2005 The Pennsylvania Gazette
Last modified 07/02/05

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FEATURE: Insuring Against Terror