NCPA - National Center for Policy Analysis

Insuring Against the Risk of Terrorism

October 25, 2001

Facing claims of at least $40 billion for the World Trade Center attacks, retail insurance companies are considering exclusions for terrorist damage, leaving property owners unable to buy coverage.

The reinsurance market -- the wholesale market where insurers lay off large risks to pools of investors willing to absorb them -- is paralyzed.

Natural disasters present manageable risks because insurers know roughly how frequently they occur, and the magnitude of the property damage that might be expected. But insurers do not know how to quantify the risk of terrorist attacks. Thus, the insurance industry would like the federal government to become the insurer of last resort against terrorism.

However, another way to supplement traditional reinsurance markets is catastrophe bonds.

  • Catastrophe bonds, also called "cat bonds," are generally sold to large institutions, and have typically been tied to natural disasters like earthquakes or hurricanes, but they could be used to provide financial backing for terrorism insurance.
  • A financial intermediary -- a reinsurance company or an investment bank -- issues a bond tied to a particular insurable event, like a Los Angeles earthquake.
  • If there is no earthquake, investors are paid a generous interest rate; but if the earthquake occurs and the claims exceed a specified amount, investors sacrifice their principal and interest.
  • Cat bonds are a form of "contingent security," a concept first formulated by Kenneth J. Arrow of Stanford University.
  • Rather than sharing known risks by pooling funds, contingent securities transfer risk to large investors.

Commodities future markets also allow shifting of widespread risks, such as a freeze in Florida orange groves, to investors who are paid to absorb it.

Economist Hal R. Varian says sharing risks through market mechanisms is preferable to "risk shafting," which is when taxpayers are left holding the bag.

Source: Hal R. Varian, "The Case For Catastrophe Bonds," Economic Scene, New York Times, October 25, 2001.


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