Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [138]
The Role of Terrorism Insurance
On September 4, 2001, my wife Gail and I arrived in New York City to begin a one-year sabbatical at Columbia University’s Earth Institute. I learned about the terrorist attack of 9/11 while riding a bicycle along the Hudson River and listening to my portable radio. There was first an announcement that a small plane had hit the World Trade Center (WTC). I then rode out to the edge of the 69th Street Pier to see the first building on fire but left the scene one minute before the second plane crashed into the second WTC tower. In the aftermath of 9/11, I worked closely with Erwann Michel-Kerjan, who joined the Wharton School in 2002. We wrote a series of papers on the role of terrorism insurance in providing financial protection against future attacks.
The attitude of insurers toward terrorism insurance is instructive. It illustrates their lack of concern with this risk prior to 9/11 and their reluctance to provide coverage after the attacks occurred. Until 9/11, insurers did not exclude damage from a terrorist attack in their policies covering property damage to homeowners and commercial firms. Moreover, they did not attempt to price this risk despite the terroristic attempt on the World Trade Center in 1993 and the Oklahoma City bombing in 1995. In other words, insurers behaved as if a future terrorist attack would not cause any serious losses to their portfolio.
Following 9/11, insurers were reluctant to offer coverage unless they were able to charge an extremely high price because they now felt the potential losses would be too costly to them. One insurance broker reported to us that an industrial firm purchased $9 million worth of terrorism insurance to cover damage to their facilities at an annual premium of $900,000. If the premium reflected the expected loss, this implies an annual probability of 1 in 10 (i.e., $900,000/$9 million) that such an event would occur.
Since 9/11, the Wharton Risk Center has been actively involved in examining the appropriate role of the public and private sectors in providing insurance protection against terrorism coverage and has published widely in this area. Researchers at the Center have a particular interest in ways that insurance can be utilized for encouraging investments by firms in risk-reducing measures so as to reduce the consequences of a future terrorist attack.
Weak Links and Interdependent Security
Another research area stimulated by the 9/11 attacks relates to interdependent security (IDS). From a cost-benefit perspective, the problem facing any consumer or business manager can be stated as follows: What are the economic incentives for incurring the costs of investing in a protective measure if there is some chance that one will still be adversely affected by a weak link in the system? For example, an apartment owner may invest in a sprinkler system to deal with fires that start in her unit but the sprinkler may be ineffective if a fire spreads to her property from a neighbor’s dwelling.
A real-life illustration of this type of interdependency was the crash of Pan Am 103 in 1988, caused by a bomb inside an uninspected bag that was placed on a Malta Airlines flight at a small unsecured airport in Malta (the weak link in the system), transferred in Frankfurt to a Pan Am feeder line, and then loaded onto Pan Am 103 in London’s Heathrow Airport. The IDS paradigm and the necessity of dealing with weak links can be applied to a much broader range of practical problems than Geoffrey Heal and I imagined when we first began working in this area right after 9/11. For example, one of the causes of the financial crisis of 2008-2009 was the potential collapse of the American International Group (AIG), the world’s largest insurer. The weak link in AIG was a 377-person London Unit known as AIG Financial Products that was run with almost complete autonomy from the parent company.
More generally, Heal and I have been able to show that there