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Evaluating The Effectiveness of Terrorism Risk Financing Solutions

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  • Howard C. Kunreuther
  • Erwann O. Michel-Kerjan

Abstract

The 9/11 attacks in the United States, as well as other attacks in different parts of the world, raise important questions related to the economic impact of terrorism. What are the most effective ways for a country to recover from these economic losses? Who should pay for the costs of future large-scale attacks? To address these two questions, we propose five principles to evaluate alternative programs. We first discuss how a federal insurance program with mandatory coverage and a laissez faire free-market approach for providing private insurance will fare relative to these principles. We conclude that neither solution is likely to be feasible here in the United States given the millions of firms at risk and the current structure of insurance regulation. We then evaluate how well the U.S. Terrorism Risk Insurance Act (TRIA), a public-private program to cover commercial enterprises against foreign terrorism on U.S. soil, meets the five principles. In particular, we show that TRIA has had a positive effect on availability of terrorism coverage and also has significantly contributed to reducing insurance premiums. TRIA is scheduled to terminate at the end of the year, but pending legislation would extend the program for fifteen years after December 31 (HR. 2761). In this paper, we show that such a long-term extension might have important impacts on the market. This could increase the take-up rate, as prices might be even lower than they are today. We show also, however, that if TRIA were extended for a long period of time in its current form, some insurers could "game" the program by collecting ex ante a large amount of premiums for terrorism insurance, while being financially responsible for only a small portion of the claims ex post. The general taxpayer and the general commercial policyholder (whether or not covered against terrorism) would absorb the residual insured losses. This raises major equity issues inherent in the design of the program.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13359.

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Date of creation: Oct 2007
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Handle: RePEc:nbr:nberwo:13359

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References

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  1. Doherty, Neil A & Schlesinger, Harris, 1990. "Rational Insurance Purchasing: Consideration of Contract Nonperformance," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 243-53, February.
  2. Lapan, Harvey E & Sandler, Todd, 1988. "To Bargain or Not to Bargain: That Is the Question," American Economic Review, American Economic Association, vol. 78(2), pages 16-21, May.
  3. Lee, Dwight R, 1988. "Free Riding and Paid Riding in the Fight against Terrorism," American Economic Review, American Economic Association, vol. 78(2), pages 22-26, May.
  4. Kent Smetters, 2005. "Insuring Against Terrorism: The Policy Challenge," NBER Working Papers 11038, National Bureau of Economic Research, Inc.
  5. Erwann Michel-Kerjan & Burkhard Pedell, 2006. "How Does the Corporate World Cope with Mega-Terrorism? Puzzling Evidence from Terrorism Insurance Markets," Journal of Applied Corporate Finance, Morgan Stanley, vol. 18(4), pages 61-75.
  6. Samuelson, Paul A., 1967. "General Proof that Diversification Pays," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 2(01), pages 1-13, March.
  7. Kenneth A. Froot, 2007. "Risk Management, Capital Budgeting, and Capital Structure Policy for Insurers and Reinsurers," Journal of Risk & Insurance, The American Risk and Insurance Association, vol. 74(2), pages 273-299.
  8. Kunreuther, Howard & Heal, Geoffrey, 2003. " Interdependent Security," Journal of Risk and Uncertainty, Springer, vol. 26(2-3), pages 231-49, March-May.
  9. Michel-Kerjan Erwann & de Marcellis-Warin Nathalie, 2006. "Public-Private Programs for Covering Extreme Events: The Impact of Information Distribution on Risk-Sharing," Asia-Pacific Journal of Risk and Insurance, De Gruyter, vol. 1(2), pages 1-30, February.
  10. Todd Sandler, 2003. "Collective Action and Transnational Terrorism," The World Economy, Wiley Blackwell, vol. 26(6), pages 779-802, 06.
  11. Abadie, Alberto & Dermisi, Sofia, 2008. "Is Terrorism Eroding Agglomeration Economies in Central Business Districts? Lessons from the Office Real Estate Market in Downtown Chicago," Working Paper Series rwp08-019, Harvard University, John F. Kennedy School of Government.
  12. Keohane, Nathaniel O & Zeckhauser, Richard J, 2003. " The Ecology of Terror Defense," Journal of Risk and Uncertainty, Springer, vol. 26(2-3), pages 201-29, March-May.
  13. Christian Gollier, 2004. "The Economics of Risk and Time," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262572249, January.
  14. Brown, Jeffrey R. & Cummins, J. David & Lewis, Christopher M. & Wei, Ran, 2004. "An empirical analysis of the economic impact of federal terrorism reinsurance," Journal of Monetary Economics, Elsevier, vol. 51(5), pages 861-898, July.
  15. J. David Cummins, 2006. "Should the government provide insurance for catastrophes?," Review, Federal Reserve Bank of St. Louis, issue Jul, pages 337-380.
  16. Howard Kunreuther & Erwann Michel-Kerjan, 2004. "Policy Watch: Challenges for Terrorism Risk Insurance in the United States," NBER Working Papers 10870, National Bureau of Economic Research, Inc.
  17. Olivier Mahul & Brian D. Wright, 2004. "Implications of Incomplete Performance for Optimal Insurance," Economica, London School of Economics and Political Science, vol. 71(284), pages 661-670, November.
  18. Howard Kunreuther & Mark Pauly, 2006. "Rules Rather Than Discretion: Lessons from Hurricane Katrina," NBER Working Papers 12503, National Bureau of Economic Research, Inc.
  19. Howard Kunreuther & Mark Pauly, 2006. "Rules rather than discretion: Lessons from Hurricane Katrina," Journal of Risk and Uncertainty, Springer, vol. 33(1), pages 101-116, September.
  20. Erwann Michel-Kerjan & Burkhard Pedell, 2005. "Terrorism Risk Coverage in the Post-9/11 Era: A Comparison of New Public–Private Partnerships in France, Germany and the U.S.*," The Geneva Papers on Risk and Insurance - Issues and Practice, Palgrave Macmillan, vol. 30(1), pages 144-170, January.
  21. repec:cup:cbooks:9780521616508 is not listed on IDEAS
  22. Doherty, Neil A & Lamm-Tennant, Joan & Starks, Laura T, 2003. " Insuring September 11th: Market Recovery and Transparency," Journal of Risk and Uncertainty, Springer, vol. 26(2-3), pages 179-99, March-May.
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Cited by:
  1. W. Viscusi, 2009. "Valuing risks of death from terrorism and natural disasters," Journal of Risk and Uncertainty, Springer, vol. 38(3), pages 191-213, June.

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