Michael R. Powers on Terrorism Forecasting

The following excerpt on terrorism forecasting is from Acts of God and Man: Ruminations on Risk and Insurance, by Michael R. Powers:

In the aftermath of the September 11, 2001, terrorist attacks, the U.S. insurance industry confronted billions of dollars in unanticipated losses. In addition, major global reinsurers quickly announced that they no longer would provide coverage for acts of terrorism in reinsurance contracts. Recognizing that historical loss forecasts had failed to account sufficiently for terrorism events and facing an immediate shortage of reinsurance, many U.S. primary insurance companies soon declared their intention to exclude terrorism risk from future policies. This pending market disruption led the U.S. Congress to pass the Terrorism Risk Insurance Act (TRIA) of 2002 to “establish a temporary federal program that provides for a transparent system of shared public and private compensation for insured losses resulting from acts of terrorism.” Subsequently, Congress passed the Terrorism Risk Insurance Extension Act (TRIEA) of 2005, which was similar (but not identical) to the TRIEA.

From the U.S. Treasury Department’s perspective, the TRIA was intended to provide protection for business activity from the unexpected financial losses of terrorist attacks until the U.S. insurance industry could develop a self- sustaining private terrorism insurance market. However, during the debate over the TRIEA, representatives of the U.S. property liability insurance industry argued that the industry lacked sufficient capacity to assume terrorism risks without government support and that terrorism risks were still viewed as uninsurable in the market.

Given that the TRIEA was extended for a further seven years at the end of 2007, the debate over the need for a federal role in the terrorism insurance market is far from over. Although the federal government does not want to serve as the insurer of last resort for an indefinite period, it is clear that there are major obstacles to developing a private market for terrorism coverage.

Certainly, no category of catastrophe risk is more difficult to assess than the threat of terrorism. In addition to many of the ordinary random components associated with natural and unintentional man-made catastrophes, one must attempt to fathom: (1) the activities of the complex networks of terrorists; (2) the terrorists’ socio-psychological motives and objectives; and (3) the broad range of attack methods available to the terrorists.

Despite these difficulties, it is possible to transfer or finance losses associated with terrorism risk. In the United States, private insurance markets for this type of risk existed before the events of September 11, 2001, and they exist today, albeit with government support under the TRIEA. Even without government support, markets for terrorism risk would exist as long as insurance companies believed that total losses could be forecast with reasonable accuracy.

Central to this requirement is that the underlying frequency and severity of terrorism losses not be perceived as fluctuating wantonly over time. To this end, the current state of risk financing has been assisted by two significant developments: (1) the lack of a substantial post–September 11 increase in the frequency of major terrorist attacks (outside of delimited war zones); and (2) the emergence of sophisticated models for forecasting terrorism losses by commercial risk analysts that, for the moment, afford market experts a degree of comfort in the statistical forecasts.

At the simplest level, the probability of a successful terrorist attack on a particular target may be expressed as the product p1 x p2 x p3 x p4 where:

P1 is the probability that an attack is planned;
P2 is the conditional probability that the par tic ular target is selected, given that an attack is planned;
P3 is the conditional probability that the attack is undetected, given that an attack is planned and the particular target is selected; and
P4 is the conditional probability that the attack is successful, given that an attack is planned and the particular target is selected and the attack is undetected.

The first of these four probabilities is essentially the underlying probability of terrorist action during a given time period. In a catastrophe risk analyst’s model, this probability is generally captured by an overall outlook analysis for a particular future time period. Unfortunately, the other—and more complex— probabilities are not handled so transparently. In fact,
it could reasonably be said that the methods used to calculate p2, p3, and p4 are buried deeply within one or more black boxes.

Essentially, the catastrophe risk analyst develops estimates of theselast three probabilities by intricate processes combining the judgmental forecasts of terrorism/security experts with the results of complex mathematical models. In some cases, the risk analyst may employ techniques from mathematical game theory (a subject to be discussed at some length in Chapter 15). Regrettably, the largest parts of these estimation techniques remain unpublished and untested, primarily because of proprietary concerns.

In a global economic culture that praises the virtue of transparency, it is rather unsettling that both rating agencies and regulators routinely countenance the use of unseen and unproved mathematical methods. Can one seriously imagine a modern patient going to the doctor for an annual checkup and accepting a diagnosis based upon a battery of secret, proprietary tests? Unless the black boxes obscuring terrorism forecasts are removed and the market’s confidence justified for the long term, one thing is clear: The next major terrorist attack may not only destroy its intended target, but also seriously damage the private market for terrorism coverage.